Not everyone can fill both their annual ISA and pension allowances to the full, which means for the rest of us it’s a choice between two tax-advantaged wrappers that can both be hugely beneficial for our finances. We may be able to partly fill both, but should we focus on one over the other? I dive into the details…
For many people, flexible access to our money may be the ultimate decider in favour of ISAs, while for others it’s the additional tax relief on pensions that wins.
Both ISAs and pensions allow your money to grow free of tax on any interest or investment gains. Known as ‘tax-wrappers’, they have become more important as governments have whittled down investment income and capital gains allowances in recent years. Now, if you make profits outside an ISA or pension, the annual tax-free capital gains allowance is a mere £3,000, while the annual dividend allowance is £500.
If you look at the tax benefits and contribution limits alone, the pension wins hands down. That’s because you can put up to £60,000 in each year (vs £20,000 in an ISA), subject to your earnings being at least that amount. But the real sweetener is with a pension you get upfront income tax on the contributions, which you don’t with an ISA.
For every £80 you pay into a pension HMRC will add another £20, with 40 per cent and 45 per cent taxpayers able to reclaim up to an additional £20 or £25 directly from HMRC. That gives your investment an instant uplift and the compoundingThe return you earn on top of your investment gains by reinvesting your profits instead of withdrawing them. effect is amplified, enabling your money to grow faster.
But there is a huge downside to pensions in terms of access. You have to lock your money away until age 55, but this will rise to 57 in 2028. For a young person, looking ahead to huge financial milestones such as paying for a wedding, a house deposit, raising children, funding their higher education, and maybe job change and redundancy along the way, locking money away for so long can feel daunting. In the worst case, it may feel like a bad decision. Or there may be the nagging worry that it will turn out to be one.
The other issue to contend with has been pensions becoming a target for governments to raise revenues. For example, the inheritance tax benefits of pensions are going to be removed. There’s a worry that other aspects of pensions may be watered down. But my thoughts on this are that you can only deal with the tax rules that we have today.
Plus, the upfront tax relief on pensions, often thought of as ‘free money’, is hard to ignore. And if your employer offers a contribution to your pension too, turning that down is like turning down a pay rise.
One simple approach can be to use a Cash ISA as a home for your family’s emergency fund and then to prioritise pensions for your investments because of the tax relief. That’s fine if you’re sure you won’t want access before age 57 (or 55). And once you reach your 50s and are sure you’re going to carry on working until retirement age, you may want to prioritise pensions.
On the other hand, if you want to retire early, Stocks and Shares ISAs really come into their own, because they can help bridge the income gap between the age you want to retire and the age you can draw your pension. If your spouse or partner is older than you and you want to retire at the same time as them, using ISAs may feel like more of a priority.
Also, the ability to take money out of ISAs free of tax, can be very helpful if you use them alongside pensions to reduce your overall tax in retirement.
When you draw income from a pension later in life, you can only take out the first 25 per cent tax free, while the rest is taxed. The overall tax benefit of pensions is magnified, if you’re a higher rate tax payer when contributing to a pension and then a basic rate tax payer in retirement. You get more income tax relief when putting money in than you pay in tax when taking it out.
In the end, when weighing up contributions to ISAs or pensions, don’t fall into the trap of endless procrastination that means you never end up making a decision, or miss the 6 April deadline for using your annual allowances. Decision making will always be a compromise as you can’t accurately predict how financial pressures in your life will pan out. Even if you choose the ‘wrong’ tax wrapper, it’s better to be using your tax-free allowances and investing for your future today, than kicking decisions into the long grass.
Tax treatment depends on individual circumstances and may change in the future. Investments can go down as well as up, and you may get back less than you invest. Moneybox or its associated third parties do not offer personal financial advice or make specific recommendations based on your individual circumstances. If needed, seek independent financial advice before making decisions regarding your financial goals.