- Calculate your pension
- Pensions tips and guide
- Best cash ISA rates
Is an ISA better than a pension? It’s a question that has been raised since ISAs were first introduced:
Increasingly – and for good reason – there is a growing sense that ISAs are preferable given the amount of stories about Gordon Brown’s Pension Tax “grab”, as well as the inability of most people to know what their pension might be on retirement.
Then there are the many stories regarding the poor pensioners who have managed to save into a scheme all their lives only to find the annuity they get barely keeps them above the breadline.
And of course, as if this wasn’t enough, maybe you’re running scared of being ripped off by absurdly high brokers’ charges.
More control with an ISA?
Not very encouraging, is it? Small wonder, therefore, that putting your money into an ISA sounds far more attractive for those of us who like to know that what we’ve saved, we will get.
It’s true the clarity and certainty of ISAs make them attractive. But is there a huge cost in opting for this approach?
The Tax Issue
There is a widely held view that the tax treatment of pensions and ISAs is broadly equal and that, as such, there should be much to choose between the two.
Unfortunately, that’s not the case.
Tax on Pensions:
The huge attraction of paying into a pension is that it will attract tax relief – and that can make a huge difference.
Essentially, you will get back the tax you’ve already paid on your earnings. For non-taxpayers and those on the basic rate, that is currently 20%. In hard cash terms this means you can expect the taxman to add £20 into your pension pot for every £100 you put in yourself. For higher rate (40%) taxpayers, the incentive is much greater still.
This is clearly a huge benefit. But the downside appears when you start taking income from your pension.
Although the rules mean you are allowed to take a quarter of your total pension pot as a tax-free lump sum on retirement, the rest will have to put into buying a standard annuity.
This is an annual sum, usually paid monthly, calculated on the basis of how much is in your pension pot, divided by the average amount of years you are expected to live.
The problem here is that this annuity income is taxed at normal Income Tax rates (although at the moment, pensioners do have a slightly higher personal income tax allowance).
With ISAs, the story is basically the other way round. You contribute into an ISA from your income after it has already been taxed but when it comes to taking your money out again, there’s no further tax to be paid.
So They Are The Same Thing in Reverse?
The big mistake many people make when comparing ISAs and pensions is that they look at them from the tax points of view - as mentioned above - and then assume there can’t be much difference between the two.
That, however, is completely WRONG.
So Where Does the Difference Come From?
The major element so many of us fail to take into account is the compound growth on the tax relief you get on contributing to a pension. This means because the payments are bigger into a pension when you include the tax relief, this all adds up to a bigger sum of money than the post-tax amounts you put into an ISA.
So What Difference Does it Make?
That, of course depends on a whole range of factors. But the two key elements are how early in life you start contributing to your pension (the sooner, the better as it gives more time for your compounded tax relief to add up) and second, how much you decide to contribute each month.
For a clear demonstration of the lengthy calculations involved in showing you how the difference between paying into a pension or an ISA add up, we advise you go to see a independent financial adviser – although that doesn’t mean you should feel obliged to take their advice or use their services.
Pensions everytime - example (source: Hargreaves Lansdown)
But taking the typical scenario of a 35-year-old, who decides to start saving a moderate £100 a month, we can get an approximate idea of what the difference would be.
Here are the calculations that prove it (all results given are after estimated inflation has been taken into account over 30 years):
Pensions calculations are based on:
ISA Calculations are based on:
- You're a 35 year-old man.
- You pay £100 net a month until 65.
- Your ISA grows at 7% a year with a 1% annual charge reducing net growth to 6% a year.
- The inflation rate is 2.5% a year.
- At 65, you use the full ISA value to buy a purchased life annuity with a rate of 5.8%.
Case 1: You get basic rate tax relief on your pension and you're a basic rate taxpayer in retirement
Pension value - £57,723 = Net pension income per year £3,198
ISA value - £46,179 = Net ISA income per year £2,600
In real terms, pension income beats ISA income by £598 a year
Case 2: You get high rate tax relief on your pension and you're a higher rate taxpayer in retirement
Pension value - £76,964 = Net pension income per year £3,437
ISA value - £46,179 = Net ISA income per year £2,523
In real terms, pension income beats ISA income by £914 a year
Case 3: You get high rate tax relief on your pension but you're a basic rate taxpayer in retirement
Pension value - £76,964 = Net pension income per year £4,264
ISA value - £46,179 = Net ISA income per year £2,600
In real terms, pension income beats ISA income by £1,664 a year
Summary of results - Pension vs ISA
If you are a basic rate taxpayer during your working life and also a basic rate payer when you retire, you could expect to be about £600 a year better off with a pension rather than ISAs
If you are a higher rate taxpayer in work and ALSO when you retire, you’d probably be better off by around £1,000 by opting for a pension
If you are a higher rate taxpayer in work but fall within basic rate income when you retire (a common scenario) you’d probably be more than £1,500 a year better off with a pension.
In all three of these scenarios, you can see that wherever you career takes you; whether you become a high-flier or not, you are almost certainly going to be better off putting your retirement savings into a pension rather than ISAs.
The clarity and certainty of ISAs does make them attractive. But unless we’re in for radical change, a pension for your retirement will almost certainly be the wisest choice.
