Title

ISA or Pension

Date

09 Feb 2017

Excerpt

Should you invest in an ISA or Pension?

Content

Should you invest in an ISA or a Pension?

The decision between choosing an ISA or a pension will often come down to how and when an individual is likely to want to access the investment.  

In this briefing we will compare the tax treatment of each, and consider the implications of pensions flexibility and flexible ISAs and how those changes impact on the choice between a pension and an ISA.

Facts and analysis

On pure tax grounds when there is tax relief on the contributions, it is difficult to beat a pension. This is particularly the case for someone who is a higher rate taxpayer when making the pension contribution and likely to be a basic rate taxpayer when they take the benefits.  The tax relief added to the contribution means more is invested and it is invested in a tax efficient fund.  When benefits are taken 25% is normally available as tax free cash, with the remainder taxable at the individual’s marginal rate.

An ISA also invests in a tax efficient fund, and although there is no tax relief on the contributions, all the benefits can be taken free of tax.

Let’s consider examples for basic and higher rate taxpayers –

  • Assuming an initial investment of £10,000 and a net return of 4% per annum after charges
  • Whole fund is taken as a lump sum after 10 years of investment 

Investment Wrapper

Initial Investment

Value after 10 years

Tax free cash

Taxable Lump sum net of tax

Total Net Return

ISA -Regardless of tax rate paid

 

£10,000

 

£14,802

 

-

 

-

 

£14,802

Pension -Basic rate taxpayer

 

£12,500*

 

£18,503

 

£4,626

 

£11,102

 

£15,728

Pension -Higher rate taxpayer at the start and basic rate taxpayer when taking benefits

 

 

£16,667**

 

 

£24,671

 

 

£6,168

 

 

£14,802

 

 

£20,970

*Net contribution of £10,000, plus tax relief at the basic rate of £2,500

**Net contribution of £13,333, plus tax relief at the basic rate of £3,333.  Client also reclaims £3,333 higher rate tax relief

The table illustrates that when you compare the 3 scenarios the pension will deliver the highest post tax return. 

There are, of course, other scenarios that you could consider, including that an individual could receive basic rate tax relief on the contribution, and then because the benefits are taken as a lump sum, that some or all is taxed at higher rates of tax.  For example, if the basic rate taxpayer ends up taking the full taxable lump sum while still working full time and it falls into the higher rate tax band, the ISA would have been more tax efficient.

When choosing the best tax wrapper for an investment, however, tax is not the only consideration. A pension is often not chosen based on lack of access or because the investment is just not considered ‘retirement money’.

Pensions flexibility has gone some way to addressing issues of accessibility. 

There are, however, a couple of important points to consider - 

  • Pensions can currently be accessed from age 55, but this is set to increase to age 57 in 2028 (when the State Pension age rises to 67), and then increase in line with changes to the State Pension age
  • If a member flexibly accesses any taxable income from their pension this will restrict the amount of any future pension contributions.  The money purchase annual allowance is £10,000 in 2016/17, but this may reduce to £4,000 from 2017/18 depending on the outcome of a current consultation.

Flexible ISAs enable an individual to take money out of the investment wrapper and then replace it.  Since 6 April 2016 an investor can replace money they have withdrawn from their ISA earlier in the same tax year.  

Conclusion

The tax story for a pension is compelling for many people, especially those who are higher and additional rate taxpayers.  A pension is also an attractive tax wrapper from an IHT perspective. Whilst an ISA will form part of the investor’s estate on death, the pension will normally be free of any tax charge on death prior to age 75, and taxable at marginal rates of tax on death age 75 and above.

An ISA, and particularly a Flexible ISA, whilst not as tax efficient in many cases, does offer more flexibility to the client. 

If you would like to talk about the best way to invest your money or how to access your pension or investments, please call us on 01604 832932.