UK Markets open in 7 hrs 59 mins

Pension vs. ISA: which is better?

Peter Stephens
Senior Couple Walking With Pet Bulldog In Countryside

Most people dream of having a retirement income that is sufficient to enjoy financial freedom in older age. Since the new state pension amounts to just £8,767.20 per year for individuals who have 35 qualifying years on their National Insurance record, it is important to begin retirement planning as soon as possible in order to have a sizeable nest egg and second income.

While it is possible to have an ISA and a pension, both have their advantages and disadvantages. Therefore, one option may be more appealing depending on an individual’s personal preferences and financial situation.

If you’re planning for retirement, here are some key characteristics of ISAs and pensions that could help your financial planning.

Tax efficiency

One of the main advantages of investing in either a pension or an ISA is their tax advantages. Investments made in either a pension or an ISA are not subject to capital gains or dividend tax, which could save an investor considerable sums of money during their lifetime.

Contributions to a pension are made before income tax is paid. This should allow a pension portfolio to grow faster than an ISA, since the government credits the value of the tax that would normally have been paid to a pension. By contrast, contributions to an ISA are made after income tax has been paid. 

However, this difference in contributions is at least partly offset when it comes to making withdrawals. For a pension, 25% of withdrawals are tax free; however, the remaining 75% is subject to income tax. In contrast, all withdrawals from an ISA are tax free.

Accessibility

A key difference between a pension and an ISA is in the accessibility of each. Contributions made to a pension cannot be withdrawn until age 55 at the earliest. With an ISA, withdrawals can be made at any time unless it is a lifetime ISA. Capital invested in a lifetime ISA can only be withdrawn after age 60, or to pay for first home before then. Otherwise, there is a 25% charge paid on withdrawals.

When compared to a pension, an ISA can provide significantly greater financial flexibility for an individual during their lifetime. This may be particularly relevant to younger investors who are unsure of their future financial position. Should they require capital to purchase a house or buy a car, for example, that money could be withdrawn from an ISA. Pension contributions, though, are locked away until retirement at age 55 or above.

Contributions

Many employers offer their employees generous pension opportunities. For example, this may take the form of matched contributions, with an employer pledging to equal an employee’s contributions up to a fixed percentage, such as 5% of annual salary. In such a scenario, it is logical for an individual to contribute to a pension, since doing so will increase the rate at which their retirement savings rise.

With it being possible to contribute up to £40,000 per tax year into a pension versus £20,000 per tax year in an ISA, higher earners may benefit the most from contributing to a pension. Such individuals may also benefit more from a pension’s income tax saving, should they be higher-rate taxpayers.

Simplicity

Budgeting while in retirement can prove challenging. As such, an ISA may be an easier way for individuals to plan their finances. As mentioned, all tax on contributions is paid before it is invested through an ISA, so a portfolio’s valuation within an ISA is the amount that can be withdrawn on a net basis.

In contrast, there are tax considerations with a pension that could make it more complex to determine how much to withdraw each year in retirement without incurring a higher rate of tax. And while there is a personal tax allowance to use up each year, the vast majority of this is attributed to the state pension, which is currently payable from age 65 for men and women.

Investment options

While a Self-Invested Personal Pension (SIPP) provides a wide range of investment opportunities, some employee pension schemes are limited in terms of where their capital can be invested. For example, they may only offer a small number of funds that do not fully capture an investor’s needs from either a risk or reward perspective.

ISAs provide a great deal of choice when it comes to where they can be invested. For example, it is possible to hold stocks and shares, cash, or even invest in crowdfunding and peer-to-peer lending opportunities through an innovative finance ISA.

Verdict

For individuals with employers who will match their contributions, paying into a pension seems worthwhile. Similarly, for consumers who will not need to access their retirement savings until age 55 or above, a pension seems to make sense.

However, the simplicity and flexibility of an ISA make it a worthwhile product for many people.

It may be prudent to consider your own circumstances and plans before deciding on a pension or ISA, with both products offering the potential to build a sizeable nest egg for retirement.

More reading

MyWalletHero, Fool and The Motley Fool are all trading names of The Motley Fool Ltd. The Motley Fool Ltd is an appointed representative of Richdale Brokers & Financial Services Ltd who are authorised and regulated by the FCA, and we are permitted in this capacity to act as a credit-broker, not a lender, for consumer credit products (our FRN is 422737). The Motley Fool Ltd does not have permissions for, and does not advise on, investment products and services, but may provide information on investment products and services.

The Motley Fool receives compensation from some advertisers who provide products and services that may be covered by our editorial team. It’s one way we make money. But know that our editorial integrity and transparency matters most and our ratings aren’t influenced by compensation. The statements above are The Motley Fool’s alone and have not been provided or endorsed by bank advertisers. The Motley Fool has recommended shares in Lloyds, Tesco and Barclays.

Motley Fool UK 2019