This post is to highlight the pros and cons of these two popular tax free savings vehicles, not to single out which one is better, as that would depend on individual circumstance & preference.
- Investments within an ISA will grow free of income & capital gains tax (aside from the 10% tax credit on dividends within stocks & share ISAs).
- ISA funds are usually readily accessible: there may be exit charges and short waiting periods but in most cases you can get your hands on your money fairly quickly. This makes them a much more flexible method of saving than a pension, especially to meet pre retirement savings goals.
- This accessibility means that ISA funds could be easily drawn upon in times of emergency. Cash ISAs would be especially useful for emergency fund purposes.
- Any money taken from an ISA is received tax free, unlike pension proceeds which are subject to income tax at the recipients prevailing rate.
- Unlike pensions, ISAs do not receive income tax relief on contributions.
- ISAs have fairly low yearly contribution limits (£5,760 – Cash, £11,520 – Stocks & Shares 2013/14), this could pose a problem for those trying to save a large sum for retirement purposes.
- The flexibility of withdrawal could also be a hindrance to long term savings goals if the temptation is there to draw on savings for other purposes.
ISA savings could affect entitlement to certain means-tested state benefits.
- On death ISA savings will form part of an estate; if this exceeds the nil rate band of the deceased any beneficiaries would be liable to inheritance tax, although with good tax planning this scenario can be largely avoided.
- Perhaps the biggest pro exclusive to pensions is that contributions receive income tax relief e.g. for a basic rate tax payer, every £80 you pay in is topped up to £100. Higher rate taxpayers would also be able to claim a further £20 back via self assessment.
- Pensions like ISAs also grow free of income & capital gains tax (aside from the 10% tax credit on dividends).
- Pension savings will not affect entitlement to state benefits if you are unemployed or made redundant.
- When you crystallise your pension you are currently aloud to take up to 25% out as a tax free lump sum.
- Pension proceeds are taxed as income at the recipients prevailing rate. Thus the tax relief given at contribution stage is more of a tax deferral. However pension savers do benefit from gross roll up of the boosted contribution, and are usually in a lower tax bracket when drawing their pension funds than when they were contributing.
- You cannot access your pension savings until you are 55; in this regard they are far less flexible than ISAs which give savers greater control over their funds.
- The government has frequently meddled with pension rules, sometimes drastically changing the goalposts for pension savers. Changes in recent past have included: increasing the minimum pension age from 50 to 55; scrapping of the 20% dividend tax credit on pensions; reducing maximum yearly contributions from £255,000 to just £50,000 and also capping maximum pension size to £1.5m (2013/14 tax year).
- On death if you have purchased a single life annuity your pension savings are kept by the provider. If you opt for drawdown any remaining proceeds will be taxed at 55% before reaching beneficiaries.
For both of these savings options, the tax relief positives largely outweigh the negative points. As pensions offer the possibility of larger amounts of tax relief, they should be more attractive to the majority of people saving for retirement. However ISAs also have a place too, especially if the savings goal is before age 55. Ideally both tax free wrappers should be fully utilised.