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Should I invest spare money into a Pension or an Individual Savings Account (ISA)?

This is a question that I often get asked so here is a guide to the basic differences between pensions and ISAs.

Firstly, a pension and ISA can, in theory, be invested in exactly the same funds or assets and what makes a pension different to an ISA or vice versa is the rules attached to that investment.

ISA – basic features
An ISA grows free of tax and can be accessed tax-free at any time. You have an annual limit of £20,000 in 2018-19.

Pension – basic features. A pension also grows free of tax but cannot be accessed until 10 years prior to state retirement age, which at the moment is 55 years old (and there are proposals that this will increase to 57 in 2028). Once you access the money from your pension you can take 25% of the fund tax-free and the rest is taxed at whatever rate of taxpayer you are at the time, so if you are a basic rate taxpayer this would be 20% tax. The interesting thing about a pension is that you receive tax relief on contributions and this is up to a maximum of £40,000 depending on what your relevant UK earnings are. If this is starting to sound a little bit complicated then I will explain with an example.ExampleLet’s take two people each earning a salary of £25,000 year. This makes them both basic rate taxpayers as they have no other income. They each want to save £100 month towards their future. To keep things simple we will assume that their savings or pension fund increases in value by 5% a year and inflation is 2.5% year. The table below shows the comparison of the different pots over time:

  ISA Pension
Initial deposit / investment £100 £100
Tax relief (basic rate) NA £25
Total Annual contribution (year 1) £1200 £1500
Interest at 5% £60 £75
Total after 1 year £1260 £1575
After 20 years £39,679 £49,599
4% of fund (drawing as income) £1,587 £1,686

You can see that by putting in the same monthly amount the pension pot grows higher due to the compounded interest on the extra contributions.

Drawing out the lump sum rather than income
Let’s say both wanted to take the full lump sum after 20 years to buy a camper van or to help with university fees/deposit for a child’s house then with the ISA, irrespective of tax status the person saving in the ISA would receive the £39,679 tax-free. The person who has invested in the pension would be able to take 25% tax-free and 75% would be taxed at their highest marginal rate. If they are a basic rate taxpayer this would be 20%. The table below shows this example:

  ISA Pension
Fund size £39,679 £49,599
Tax-free cash £39,679 £12,400
Taxable amount NA £37,200
Tax at 20% NA £7,440
Total Amount after tax £39,679 £42,159

It can be seen that after tax, the person with the pension fund still ends up with a higher amount.

Things to consider
It can be seen that in the example above the pension fund appears to offer the better option despite the payment of tax. This is just one example and It should be noted that there are many variables to take into consideration when selecting the right savings and investment vehicle.

  1. Taxpayer status – our example uses a basic rate taxpayer but if this were a higher rate taxpayer then they would be able to claim back a further 20% on the contributions at the end of the tax year
  2. The tax status of the individual when they want to take the income/lump sum – this will affect the net amount they receive with a pension but an ISA would be unaffected as it is received tax-free
  3. Access to monies – are you likely to need access to the monies prior to retirement? Remember a pension has strict rules on when the funds can be accessed
  4. Is your estate close to the Inheritance tax limit? If it is then any monies within an ISA will fall within the estate for inheritance tax purposes. In contrast monies within a pension that are held in a trust are outside of the estate so there can be inheritance tax planning advantages with a pension.
As with any investment, it is important that you know the charges that are in place and to know how your pension/savings / or investment are performing. These are generally medium to long-term funds whereby some fluctuation should be expected but ultimately the goal would be long-term growth. There is no right or wrong answer as to whether somebody should invest in a pension or an ISA as each individual will have different circumstances and objectives that they are trying to achieve.

Financial advice is a personalised process and at Veracity financial planning we make sure we understand what the client is trying to achieve so that we can help them achieve their financial goals. Our knowledge of different products and tax wrappers means we can help our clients to make informed choices.

Our Independent Financial Advisers are always happy to meet at our clients' preferred location and time and to have detailed initial discussions with no obligation.

Please contact us by calling 0115 967 0888 or email us at This email address is being protected from spambots. You need JavaScript enabled to view it.
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