Pensions vs ISAs - how do you choose?

So George Osborne has once again targeted pensioners in his Autumn Statement: he’s already brought forward planned state-pension age increases and has now further amended contribution rules. Beginning in the 2014-15 tax year the maximum annual contribution (the amount you can get tax relief on) will be cut from £50,0000 to £40,000 and the annual lifetime allowance (the total amount you can have in your pot without suffering additional tax charges) will be cut from £1.5m to £1.25m.

You may be thinking “so what?” - £40k per annum is still a fair amount to be saving. What is worrying though is the trend amongst governments to tinker with pensions when they need to encourage people to save money. If we go back just a few years the lifetime allowance was £1.8m and you could contribute a whopping £255,000 per annum into your pension. Due to the complex nature of pensions and constant ‘adjustments’ by politicians,  not to mention the volatility and disillusionment brought on by the financial crisis of 2008, many savers are starting to ask themselves why bother? Some are considering ISAs as a simple alternative with the added benefit of instant-access.

On the surface it seems that ISAs may win out in some respects: you can currently save up to £11,280 a year in a stocks & shares ISA and you’ll pay no income tax when you withdraw it (unlike pensions). Best of all you can access the money whenever you want whereas with pensions you are at the mercy of the government’s rules on when you should be able to access it. Furthermore, due to their simplicity and popularity they tend to be relatively immune to government fiddling – after all, removing an ISA’s principal benefit of tax-free growth and withdrawals would kill the product completely.

But we’re forgetting two important things: tax-relief on pension contributions and what Einstein allegedly called the eighth wonder of the world – compound interest. If you put £10,000 into an ISA today it could grow to be worth nearly £34,000 in 25 years time¹ – a long time, I know, but even for a 40 year old today this still wouldn’t take them to the state pension age! Had they invested this in a pension instead they could have over £56,000 in their pot had they been a higher rate tax payer at the time of contributing. That’s a massive 66% more money in their pot than had they saved into an ISA!

So it’s a no-brainer then, pensions are actually better? Not exactly; you need to consider what the tax implications will be when you come to retire. Obviously no-one can predict this and ISAs may get tinkered with as well, but we can consider how things would be today: you could withdraw your £34k ISA money as and when you pleased with no tax to pay. However, the £56k in a pension would benefit from a tax-free lump sum of 25% but income tax would have to be paid on the rest which could erode much of the benefits gained whilst saving depending on your own tax situation before and after retirement.

This is why good financial planning is vital – your own individual and unique circumstances will determine how you should be saving for your retirement. You might be a higher or additional rate tax payer just now but plan to be a basic tax payer upon retirement. You may have other sources of income that will affect your tax situation in retirement and may change the best way to save for you retirement.

Osborne left the 40% and 50% tax-relief untouched this time round which makes pensions a very sensible option for these tax payers – but how long will this last? Perhaps a balance of ISA and pension investments is the best solution. If you’re concerned that you may not be sufficiently prepared for your retirement contact us for a discussion about your financial needs. It’s never too early (or too late) to start.

1 Assumes 5% growth – you can decide whether or not you feel this is too optimistic!