Hello, I am a fool and I hadn’t been saving anything into an ISA until January 2015. All of my savings were either in cash (outside of an ISA for a better rate), company share options or the company pension.
So what do you do? Save into a pension or an ISA?
A pension gives us tax relief on our contributions so we have more money going into savings in the first place, and any withdrawals are then taxed as income. Woop! An ISA, on the other hand, has already been taxed and all contributions thereafter are tax free, both on capital gains and any income. Woop! But which is better? The pension looks like it at first glance, there is more money to compound right from the off as we get tax relief from the off.
Lets start with a simple numerical example.
Columbo has £10,000 to invest as a lump sum. Assuming a 5% return, a 10 year horizon and 3 various tax bands (before being whilst working and after being during retirement)…
|Pension Vs ISA|
So where our tax before and after is the same, there is no difference in the net fund we have at the end of the period.
But, where our tax is greater whilst working, compared to retirement, the pension wins. This could quite easily be the case, for example if you are a higher rate tax payer whilst working it is possible that in retirement you will pay normal rate tax (or even no tax if your income was below the annual tax free allowance). I didn’t include examples where the tax rate is higher in retirement, as that seems pretty unlikely.
The Pension seems an obvious winner here. But this is a very simple example and there more powerful forces at work… let battle commence.
The Pension’s Jab: More effective tax relief
See above 🙂
The Pension’s Uppercut: Employers Contribution
The ever sneaky pension becomes even more valuable when you include the employers contribution. For example your employer may match your contribution up to 5%, which means for each 5% contribution that you pay, your pension actually receives 10%. You get a 100% return on your money immediately. A big win for the Pension and one that’s hard to ignore,
The Pension’s X2 Combo: The Tax Free Lump Sum
The current rules allow you access to 25% of your pension pot tax free, after normal retirement age. This money could then be drip fed into an ISA each year for further tax free growth. Of course this is not written in stone. It’s more likely to have been written in flour in the middle of a very busy and very windy street. The government may well take this benefit away in the future.
The Pension’s Round House Kick to the Face: Drawdown
New rules now mean you aren’t forced to by an annuity on retirement and you are free to access and invest your pension as you see fit. This is a great improvement to the flexibility of the Pension.
The Pension’s Baseball Bat to the Kneecaps: Higher annual contribution limit
You can only put £15,000 into an ISA each year. The tax free limit for a pension is currently £40,000 a year. A small win for the pension here.
The ISA’s Hadouken: Flexibility
(Ignoring SIPPs here). The ISA is generally much more flexible than an employers pension, that may only offer you access to a limited number of managed funds…which could have an hefty AMC or a shite fund manager. By investing in shares/funds in your ISA you generally have much more flexibility.
The ISA’s Holy Hand Grenade: Diversification
You don’t have to hold all of your ISA investments with the one broker. In my eyes this is a huge benefit. Diversification shouldn’t just be limited to which shares/sector/fund/country you are investing in, but the providers themselves.
By diversifying our holdings among multiple providers we are protecting ourselves against losing all of our money should a single provider go bust. Some of your money would be safe guarded anyway by FSCS compensation, between £50k and £85k depending on the provider.
(EDIT: in the above comparison I was only referring to the company pension situation, where you need to contribute to the employers scheme in order to benefit the employers pension contribution. If you are investing in SIPPs then you could have multiple providers. Result!)
The ISA’s 1UP Mushroom: Access
You can’t get access to your pension before you are at the normal pensionable age (currently 55), at least not without heavy taxes being taken. As UTMT said, “Tax is a shit”. The ISA is not subject to the same rules as the Pension here, and you are free to access your savings earlier if needed….say for financial independence. This is a huge win for the ISA. (Although, if you keep raiding your savings with your greedy wee hands the ease of access could be a disadvantage.)
They both have their merits and there isn’t an obvious winner. The Pension seems a more tax efficient choice, but it is burdened by additional regulation which could change at the governments whim. It does seem a riskier choice. The ISA is a much more flexible choice and simpler.
I am going to reduce my Additional Voluntary Contributions (AVC’s) and only contribute what I need to get the maximum employers contribution. This will be a nice bonus when I hit the pensionable age.
The recent payrise and the amount that was going to AVC’s will now be pounded into a stocks and shares ISA.
By using both I can max out on the company’s contribution (effectively a payrise or free money), get some extra diversification (both regulation and provider) and get the extra flexibility of an ISA.
What say ye? Pension or ISA? What have I missed?
Spend less, save more and escape the Horde