Comparing ISAs to pensions

When thinking of investing for the future, ISAs and pensions are likely to be at the front of most people’s minds. 

They are certainly two forms of investment that crop frequently in the conversations our expert team of financial advisers at PIL Southampton have with their clients daily.

So, let’s look at these two types of tax-efficient investments and answer the questions we are most frequently asked.

What is an ISA? 

An Individual Savings Account – ISA – is a way of saving up to £20,000 each tax year, without having to pay tax on the returns. 

Cash ISAs are like standard savings accounts, where you receive interest on the money you save.

Stocks and shares ISAs invest your money, and your returns are in the form of any gains your investment make. However, the value of your investments can go down as well as up so you could get back less than the amount you invested.

Both Cash ISAs and Stocks and shares ISAs are available as Lifetime ISAs, which we talk more about further on in this article.

What is a pension? 

A pension is a saving scheme specifically designed to build a savings pot for your retirement. It’s a long-term investment that can’t be accessed until you reach a certain age. 

All pensions are invested, so they all have the potential to lose money as well as increase in value.

There are three main kinds of pension in the UK – state pension, workplace pension and private pension.

Which is a better investment, an ISA or a pension? 

There is generally no right or wrong answer to this question, as it depends on what financial goals you are aiming for. 

However, if you are looking to invest towards your retirement, with the motivation of funding your lifestyle in later life, a pension is probably going to be your best option. For most people, their overall pension fund will be made up of their state pension, one or more workplace pensions if they have been employed, and one or more personal pensions that they may have set up themselves during their working life.

ISAs, on the other hand, can be a shrewd way to save tax-efficiently for specific life events, like a deposit to get on the housing ladder, or when you are planning to start a family or pay for an expensive one-off life event like going travelling or paying for a wedding.

And, the beauty is, you don’t have to choose one or the other. You can save into ISAs and pensions at the same time.

What are the investment limits for pensions and ISAs? 

Everyone has a total annual ISA allowance of £20,000, at the time of writing. That £20,000 can be spread across more than one ISA if you choose.

The annual pension allowance is £60,000 and, if it’s a workplace pension, your employer is legally obliged to contribute to your pension pot.

Should I invest in a stocks and shares ISA or a pension? 

To help you decide, it’s worth looking at some key differences between the two. 

Tax implications

Where pension funds are concerned, tax relief applies to either:

1) up to 100% of your earnings 

or 

2) the first £60,000 you pay into it.

Most pension pots allow you to withdraw up to 25% of its value tax free, and it won’t affect your personal tax allowance.

If you take out more than 25%, you will be taxed on that amount. This amount will be included in your overall income, which may mean that you cross the threshold into a higher tax bracket.

There is no government tax relief on the payments you make into an ISA, but there is also no tax payable on any of your ISA’s value.

Fees and charges

With an ISA, service and fund charges will apply, the terms of which will be clearly set out by your provider.

Regarding your pension/s, each one will charge an annual management fee, even if you’re not actively paying into it anymore. Usually, the management fee will be either a percentage of your total savings or a fixed sum.

Estate management

Your pension can go to your loved ones outside of your estate which means that Inheritance Tax will not be levied on its value. Whether it does, depends on the type of pension you have, how it was set up, and whether you have already been accessing your pension savings at the time of your death.

Note: Access to your money is another key difference between ISAs and pensions, that we cover separately later in this article.

Will I make more money from an ISA or a pension? 

There is no simple answer to this question. Many factors come into play, like the investment choices you make for your ISA or pension but, overall and over the longer term, you can expect a pension to generally have a better return than an ISA. This is because workplace pensions are topped up with contributions from your employer of at least 3% of your salary, they are typically held for longer and money invested over a longer timeframe usually yields greater returns. 

Personal pensions get tax relief from the government whereas, out of the whole range of ISAs on the market, only Lifetime ISAs (LISAs) get a financial bonus from the government – this is 25% of whatever savings you invest in your LISA, and this bonus is capped at £1,000 per year. 

Can I access my ISA or Pension when I need the money? 

You can only start taking money out from a pension fund when you reach the age of 55. This minimum age limit is rising to 57 from 6th April 2028.

With most types of ISA, including stocks and shares ISAs, you can withdraw your money at any time, although the longer you keep your money invested the more money you are likely to make from your investment. 

Investments can fluctuate in value on a day-to-day basis. Whenever you choose to withdraw your funds, you could lose money if the markets happen to be performing badly that day.

As Lifetime ISAs are specifically for saving towards your first home or for your retirement, you will have to pay back the government’s bonus of 25% if you take the money out for any other reason before you reach 60 years of age.

Some fixed-rate cash ISAs charge a penalty if you choose to access your money before the end of the fixed-rate term you agreed with your provider.

Lifetime ISA or pension – which is better? 

A Lifetime ISA allows you to save up to £4,000 each tax year until your 50th birthday, at time of writing, with the government adding a 25% bonus on whatever you save, so a maximum of £1,000 per tax year.

The annual savings limit of £4,000 is lower than the annual pension allowance. With a pension you can also access your pension funds at the lower age of 55, compared 60 before you withdraw your Lifetime ISA funds without losing the government’s 25% bonus, assuming that the ISA is not being used towards a house deposit.

Additionally, the age limit for opening a Lifetime ISA is currently 40, whereas you can open a pension and get the tax benefits from that up until the age of 75.

If you have spare money to invest in a Lifetime ISA for retirement purposes, it can be a useful addition to your retirement pot but, in many cases, it wouldn’t necessarily suit your retirement needs better than a pension scheme.

Cash ISA or pension – which is better?

The returns of a cash ISA, which are tax-free, are based on the interest rate of the cash ISA product you choose; each provider will offer various rates so it’s worth shopping around or going to an expert financial adviser, like the team at PIL Southampton, who have up to the minute knowledge of the products available at any time.

Pensions, like stocks and shares ISAs, are investments which means that any gains or losses are directly impacted by the performance of the markets.

Which option is better for you depends on your circumstances, your savings goals and your attitude to risk.

In conclusion, when you are choosing where to invest, think about your savings goals, how much you can afford to save and whether you would like your employer and the government to make contributions.

Whichever type/s of investment you decide are best for you, it’s fair to say that the earlier you can start saving the better, however little you can afford to put away each month.

How PIL Southampton can help you 

Our experienced, friendly team of financial advisers has a thorough understanding of pensions and ISAs. They will make sure they understand your needs, so that they can provide you with options that should be best suited to you and what you would ideally like to achieve. 

How you can contact PIL Southampton

You can email us, fill out the contact form on our website or call us on 02380 668407. We look forward to hearing from you.