Pensions vs Isas: Pros and cons

By THIS IS MONEY
Updated:

 

There is an ongoing debate over whether savers are better off saving for retirement by eschewing pensions and opting for Individual Savings Account (Isa) plans.

Crystal ball

Both are tax efficient wrappers offering their own unique set of benefits, as well as pitfalls. And of course, in the spirit of diversification of options, savers should consider holding both.

We highlight the main benefits and drawbacks of each.

ISAs

Individuals aged 18 and up, for the 2009/10 tax-year can invest £7,200 into a stocks and shares, or equity Isa (or £10,200 for those over 50), and up to £3,600 (£5,100) of this can be invested in cash but if you wish you can invest the full amount into stocks and shares.

From April 2010, everyone over 18 years of age will be able to save up to £10,200 per annum, of which £5,100 can be in cash.

Pros

• Both cash and investment Isas are free of income and capital gains tax (CGT). On the other hand, when you start drawing on your pension, your income is taxed;

• Isas investors are free to withdraw capital or income at will;

• ...Isas are therefore more suitable for short and medium term financial planning;

• Isas give access to a diverse range of investments, many that are low cost, which many pension funds don't offer (although a wide range is available via Self-invested Personal Pensions).

• Investors can give away their Isa savings while they are alive and thus curb their potential inheritance tax liability.

(Remember the easiest way to avoid inheritance tax (IHT) is to make 'gifts', which can be done with Isa savings. Every tax year you can give away £3,000 that won't count towards your estate. And if a gift is regular, comes out of income and does not affect your standard of living, any amount can be given away. In addition, transfers between spouses, is also free of IHT, when you are both alive. Read more on IHT, and check out our IHT guide here)

 

• Don't miss the debate on savings vs annuities

 

Cons

• No tax-saving on the way in. £1,000 invested in an Isa starts at £1,000. So the final pot from an Isa would, all other things being equal, be far smaller than what would be achiveved by a pension, which is more tax-efficient (see below).

• When an Isa investor dies, their assets are incorporated into their estate and will be potentially subject to IHT charges of 40% for all assets over the present £325,000 threshold. • Isa savers and investors are limited to what they can save annually. From April 2010, everyone over 18 years of age will be able to save up to £10,200 per annum, of which £5,100 can be in cash (rising from the current £7,200 and £3,600 respective limits - those over 50 can currently save £10,200 - see above).

PENSIONS

With personal pensions, the minimum contribution levels can be as low as £25 a month - making plans accessible for most people. Savers get tax relief on the contributions they make to company and private pensions.

This means that any contributions you make will effectively be topped up with extra money from the Inland Revenue. A basic rate taxpayer gets 20% tax relief while a higher rate payer gets 40%.

Pros

• By paying into a pension, you are essentially getting a return on your income tax. So, to invest £1,000 in a pension, you only need to pay £800, based on the present 20% uplift for basic-rate tax payers, or just £600 for higher rate payers (40% uplift).

• For a basic rate taxpayer, this £800, boosted to £1,000, with the benefit of tax relief, could grow to £1,790.85 after 10 years, (assuming annual net growth of 6%). But the same £800, would just grow to just £1,433 in an Isa, as there is no tax uplift on the way in.

• From an inheritance tax perspective, pensions are arguably more attractive than Isas but only prior to retirement age. In the case of death before retirement a pension can pay out the full value of the pot, plus the tax relief granted on the contribution free from IHT.

• Like Isas, there is a limit on how much you can save in your pension too. This amount is up to 100% of your earnings and for the tax year 2009/10 is capped at £245,000, with the limit set at £3,600 for low or non-earners paying into personal and stakeholder pensions.

(As well as the annual allowance, there is also a lifetime limit on your entire pension savings, including any private pensions, occupational pensions and free-standing additional voluntary contributions. In the tax year 2009/2010 this amount is £1.75m, with the threshold expected to rise over the years to allow for the impact of inflation.)

Cons

• You cannot access your pension pot until you reach 50 years of age, rising to 55 from April, 2010. You can then draw 25% a tax-free lump sum.

• Pension savings are subject to much tight restrictions than Isas as to how they are paid out, and therefore savers have less control, especially as they have to buy an annuity by age 75. Pension holders should ALWAYS shop around for a better annuity rate: See our annuity campaign

• You have to pay income tax on the money paid out from your annuity. Given the state of public finances and the large liabilites of an ageing population, today's tax rates of 20%, 40% and 50% (from next year) may be far higher by the time you retire.

• Pensions, from an IHT perspective lose their attraction post retirement. HMRC have gone quite a long way to ensure that once retirement has been reached investors cannot pass on any more than a token amount as a capital sum to inheritors - except for a spouse.

›› It is important to bear in mind that access to capital is a mixed blessing. If the intention is to save for retirement, then the fact that the investments can be cashed in before retirement is not necessarily a good thing.

Updated December 2009, Philip Scott, This is Money

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