Pension vs ISA

With just over two weeks to go until the end of the tax year, there is still time to exploit any remaining opportunities to invest tax-efficiently for the future. The chancellor’s decision to freeze Income Tax thresholds and the Capital Gains Tax exemption for the next five years underlines the value of tax shelters such as pensions and ISAs. But which is the best option?

There is little dispute that a pension is the most tax-efficient vehicle available to UK savers. Yet savers were often discouraged because access was restricted. Yet all that changed with the introduction of pension freedoms in 2015, which enabled savers to access their pot freely from the age of 55 onwards. The legislation also allowed individuals to choose who received their pension fund after they’d died.

Unlike pensions, ISAs don’t receive tax relief on contributions; and, of course, active members of workplace pension schemes also benefit from employer contributions of at least 3% of their qualifying earnings. However, the simplicity, accessibility and flexibility of ISAs has made them an incredibly popular savings option since their introduction over 20 years ago. At the end of 2018/19, over £584 billion was held in ISAs.2

Using pension to reduce tax and reclaim allowances

Another advantage of making personal pension contributions is that it has the effect of reducing your taxable income, which means you can avoid the loss of certain benefits and allowances. Payments into an ISA do not provide the same potential benefits.

For example, if you have a net income of £125,000 or more in this tax year, you will lose all your entitlement to the personal allowance; but by making a net pension contribution of £20,000 (£25,000 including basic rate tax relief), you could bring your taxable income back down to £100,000 and get your whole personal allowance back.

What’s more, if you’re a higher rate taxpayer, you could claim an additional £5,000 in tax relief via your self-assessment return. The same process can help individuals to bring their income below the additional rate tax band – which starts at £150,000.

Pension contributions can also help families avoid losing Child Benefit, which is lost if one parent or partner in the household earns more than £50,000. For example, someone earning £52,000 would have to repay 20% of any Child Benefit they receive via self-assessment. But if this individual contributed £2,000 (gross) into a pension, they would be able to retain their full Child Benefit payment and avoid a tax charge.

Options for income in retirement

One argument put forward against pensions is that income taken in retirement is potentially taxable, whereas funds from an ISA can be accessed at any time without any tax liability.

The tax savings on income taken from ISAs in retirement can be considerable, as illustrated below. “But it’s important to remember that 25% of a pension fund can be taken tax-free and, if available tax allowances are used carefully, income can be taken relatively tax-efficiently,” says Kavanagh.

“Additionally, pensioners typically pay lower rates of Income Tax than they did while they were working which means that, in the vast majority of cases, the tax relief gained when putting money into a pension is more than the tax rate on the money taken out.”

One other point to consider is whether to prioritise taking income from your ISA savings to leave more of your pension benefits intact, which would enable more of your estate to pass to your beneficiaries tax free.

Act now

The Budget sent a clear message that effective tax planning will become even more important in the years, and decades, to come. That will need individuals to make the most of all opportunities to reduce their tax bill, and families to pool their resources together to get the maximum value out of their wealth.

The remaining weeks of this tax year, and the beginning of the next one, provide immediate opportunities to help ensure your financial wellbeing.

The value of an investment with St. James's Place will be directly linked to the performance of the funds selected and may fall as well as rise. You may get back less than the amount invested.

The levels and bases of taxation, and reliefs from taxation, can change at any time and are generally dependent on individual circumstances.

1Office for Budget Responsibility, March 2021

2HMRC, Individual Savings Accounts Statistics (ISA), June 2021