This is one of the most asked questions in investing in the UK, and one that’s important to get right. Annoyingly, it’s also one that there’s not one easy answer to. I’ll aim make it clear enough that your answer should be right for you.
The basics — what are we actually comparing?
There are more than one type of both ISAs pensions, so what are we comparing?
- Stocks and Shares ISA: tax free growth, flexible access, £20k annual allowance and tax free withdrawals
- Defined Contribution ISA: either personal (SIPP) or through your work, taxed on the way in, tax free growth, taxed on the way out, can’t access until you’re 57 (soon to be 58)
ISAs also have Lifetime ISAs (which we’ll touch on briefly), cash ISAs which are more aimed at short term cash holding rather than long term investing, and Innovative Finance ISAs, which are not a beginner investor product.
Pensions also have defined benefit pensions, where your company guarantees an income when you retire. These are increasingly rare and usually a good idea to join, so are not what we’re looking at here.
The case for the pension first
The argument for pension sounds great in news articles. A basic rate taxpayer paying in £80 gets £100 of pension, an instant 25% return! That’s just not true though. The state pension currently takes up essentially all our zero rate band, so you will be taxed £20 on that £100, taking you to…£80. So no tax relief at all.
So why do people love pensions?
- 25% tax free: you can take 25% of your pension pot tax free, up to a maximum £268,275. A popular perk that is a huge enticement to pension savings.
- Salary sacrifice: if your workplace allows salary sacrifice you can make pension contributions with reduced or zero national insurance. Pensioners don’t pay this so there would be a genuine tax saving.
- Retiring in a lower tax band: If you work in a higher tax band to the one you retire in, you can save tax, e.g. putting away money when you’re in the 40% tax band but retiring in the 20% tax band will lead to a 33% return (£60 pre-tax to £100 pension to £80 post tax, a £20 return on your £60).
- Employer match: This is a biggie. Your employer will often match (or even more than match) any money you put in, for an instant 100% return on investment.
- Bankruptcy protection: This is especially important for self-employed people; if your business goes bankrupt and is connected to your personal finances, your pension is sometimes the main asset you are left with.
- Raid-free savings: You can’t access your pension until you’re 57 (and this number is occasionally increased). To some this is a pain, to others it stops them from spending their savings. 4 decades is a long time to be working and resist spending your savings on an exciting splurge!
There used to be inheritance tax benefits but these are going to be removed in the near future, so not worth taking into account.
The key ones are employer match and retiring in a lower tax band. If you have employer match you’re not fully using or you’re at least a higher rate taxpayer, pension savings become very tempting.
The case for ISA first
ISAs are better known to the public, mostly through their very popular cash ISA. The shares one is full of benefits though that make it worth considering. So what are its advantages over a pension?:
- Flexibility: you can withdraw money any time in an ISA, whereas in a pension it’s trapped until you’re older. If you change your plans and need to buy a house, start a business, have a career break or help your child get set up in life, you can use the money in the ISA at any time.
- Tax free withdrawals: most comparisons between pensions and ISAs look at how easy it is to build up a large pot. Even if you build up a larger pension, you need to pay (income) taxes to get it out. ISA money is already taxed, making ISAs a lot more attractive than they first appear.
- Simplicity:
- Early retirement:
- Less government risk: in a pension your money is trapped for decades, so you have to hope that many different governments don’t get tempted to raid your money for a budget shortfall. The quick access of ISAs means that if it looks like a raid is coming, you can usually withdraw your money before bad things happen.
If you want to retire early, start a business, buy a house or take career breaks, the flexibility of ISAs is really helpful. If you’re a basic rate taxpayer the tax free withdrawals mean that the tax treatment is very competitive compared to pensions, without all the complexities and rules of pension investment.
The employer match rule
I’ve mentioned it earlier but I want to make this clear. For most people, getting the full employer match is for most people the best option. If you don’t need the money soon and your employer will match 5% of your salary put into a pension, that’s a 5% pay rise that you can give yourself.
The tax bracket question
Once you’ve got your employer match, the most important factor is probably your tax band:
Higher rate taxpayer (earning over £50,270)
If you’re a higher rate taxpayer, each £60 you put becomes £100 in your pension, even more if you are using salary sacrifice or are an additional rate taxpayer. This makes it very quick and painless to build up a serious pension pot while you’re in your prime earning years.
This makes pension investment the go-to investment priority for the majority of your long-term investments. Don’t forget that you pay tax on your withdrawals though, especially if you expect to still be a higher rate taxpayer in retirement, although the 25% tax free allowance does soften this.
Basic rate taxpayer (earning under £50,270)
Pension tax relief is 20%, which sounds great until you remember that it’s also 20% when you take money out, and the state pension takes up virtually all the tax free allowance these days. For basic rate taxpayers, the benefits are therefore much less:
- You usually still get an employer match of some kind, which can be very valuable
- The 25% tax free allowance will make the numbers a little better than they first seem
The flexibility of ISAs therefore is a lot more attractive to basic rate taxpayers.