Should I invest into a pension or an ISA?
Investors looking for tax-efficient ways to build a nest egg for retirement often look to both Individual Savings Accounts (ISAs) and pensions. Tax-efficiency is a key consideration when investing because it can make a considerable difference to your wealth and quality of life.
However, the type of investment and tax-efficiency is a common dilemma faced by many people. Which is better – an ISA or a pension? In truth, there’s a place for both, and it’s easy to argue the case for each of them. ISAs allow you to invest in the current 2019/20 tax year up to £20,000 each year, providing tax-efficient growth and income. Withdrawals are tax-free because the money paid in was from after-tax income. Pensions are also very tax-efficient. All contributions within allowance limits receive tax relief from the Government payable at up to your highest rate of tax. For example, it would only cost a basic-rate taxpayer £80 to contribute £100 into their pension because they would receive tax relief at 20%. This is added to the £80, representing the 20% tax they would have paid if they had earned that £100. For higher earners, it is even better, with higherrate taxpayers able to claim back up to a further £20 and additional-rate taxpayers being able to claim back up to a further £25 via self-assessment. Tax relief is given on personal contributions up to 100% of your earnings (or £3,600 if greater). If total contributions from all sources, including your employer if applicable, exceed the annual allowance (£40,000 for most people but can be less for higher earners or those who have flexibly accessed a pension), you will suffer a tax charge on the excess funding if it can’t be covered by unused allowances from the previous three years. So, pensions give you tax relief on money going in, but when it comes to drawing on your pension, tax will be payable at your marginal rate apart from the tax-free lump sum (normally 25% of your benefits). ISA investments don’t allow for tax relief on the money being invested, but they do give you total tax exemption on any gains made within the ISA. So with an ISA, when you come to withdraw funds, you will not pay a penny of Income Tax or Capital Gains Tax. Put simply, the right option will be different for different people. There will be some for whom the right answer is a pension, others for whom the right answer is an ISA. If it was clearly one or the other, it would be far simpler. An important point to remember is that you cannot normally access your pension until age 55, whereas your ISA is accessible any time.
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| Pension | ISA | |
|---|---|---|
| Funds in | Income tax relief on contributions at up to the highest marginal rate | No tax relief on contributions |
| Investment returns | No tax paid on income and gains | No tax paid on income and gains |
| Funds out | 25% of fund paid as tax-free cash. Remaining fund subject to Income Tax at highest marginal rate | Not subject to Income Tax or Capital Gains Tax |
| Death Benefits pre-75 | Paid as a lump sum or drawdown to nominated beneficiary free of all tax | Forms part of estate and subject to IHT if estate exceeds nil-rate band and not left to exempt beneficiary. |
| Does not normally form part of estate | Spouse/civil partner can inherit additional ISA allowance based on value of deceased’s ISA funds | |
| Death benefits post-75 | Taxed at beneficiary’s marginal rate | Forms part of estate and subject to IHT if estate exceeds nil-rate band and not left to exempt beneficiary |
| Does not normally form part of estate | Spouse/civil partner can inherit additional ISA allowance based on value of deceased’s ISA funds |
