Pensions vs ISAs
Tax Relief vs Tax-free
You have until April 5th to use your ISA or pension allowance for the current tax year.
Remember you do not have to invest this money in shares. You can also put it into low risk Government bonds or keep it in cash.
A lot of financial advisers are currently recommending corporate bonds which pay around 6-7% interest. However, these investments can result in significant capital losses.
How Much Can I Invest?
You can invest up to £3,600 in a cash ISA, £7,200 in a stocks and shares ISA, or a bit of both. Couples can, of course, double up their contributions.
With pensions, you will normally get tax relief on contributions up to the amount you earn and even non-taxpayers, such as non-working spouses, can contribute £2,880, to which the Government adds £720 for a total investment of £3,600.
However, an annual allowance (£235,000 for the current tax year) applies to restrict the total permitted increase in your pension funds each year. There is also a lifetime allowance (currently £1.65m) which restricts the total cumulative value of all your pension funds. Exceeding either allowance results in punitive penalty charges.
ISAs versus Pensions
Both pensions and ISAs allow your money to grow tax free within the fund.
ISAs provide no up-front tax relief but payouts are tax free. Pension contributions enjoy tax relief but payouts are mostly taxable. The two tax breaks may appear very similar, but they produce tax savings at different points in time. The question is: which provides the more valuable tax shelter?
If when you retire you go from paying 40% tax to 20% tax – as many people do – a pension will probably save you more tax than an ISA.
Why? Because your pension contributions will have enjoyed tax relief at 40%, but your ISAs will only end up saving you 20%.
Another reason pensions are often better for saving tax is that not all of your money is taxed when you withdraw it – you can extract 25% as a tax-free lump sum.
Thanks to these two factors, it is quite possible that a pension will generate 40% more after-tax income than an ISA!
Having said all that, ISAs offer two unique benefits which are extremely important in the current economic climate:
- Emergency cash. You cannot get hold of your pension savings until you are 55 (50 before 2010). It’s a fat lot of good having £100,000 sitting in your pension pot if you desperately need emergency cash now. With ISAs you can withdraw money tax free at any time.
- Future tax rises. Because ISA payouts are tax free, they provide a hedge against future increases in tax rates. We already know that the top income tax rate will be increased to 45%. Who knows what other horrors lie in store as the Government tries to reduce its massive debts?