As tax relief reduces for pensions, investors are beginning to weigh up their options for saving for retirement. With further increases to the annual ISA allowance, savers are increasingly turning to ISAs to support their tax-efficient savings plan.
While both are considered tax efficient ways of saving for retirement, they carry very different rules and tax treatment.
Tax relief on contributions
Pensions: Your pension contributions are treated as though they are made net of income tax, and you can receive tax relief at the highest rate of income tax that you pay. This tax relief is added to your pension pot. For example, a basic-rate tax payer that makes a pension contribution of £80 will have a further £20 contributed to the pension pot as tax relief, totaling a £100 gross contribution. The way the tax relief is claimed depends on the type of pension scheme and if you’re a basic or higher-rate tax payer. You are eligible for tax relief within your annual and lifetime allowances.
ISAs: There is no tax relief for money on the way in to an ISA.
Pensions: From tax year 2019/20, the annual allowance for pension contributions is capped at £40,000, but your allowance could be reduced if you have a high income. You’ll not receive tax relief on contributions over your annual allowance, or on pension contributions that are over 100% of your net earnings. You can carry over unused allowance from the previous 3 tax years if you use your full allowance in the current tax year.
ISAs: The current (tax year 2019/20) annual allowance for investing in an ISA is £20,000. It’s a “use it or lose it” situation – if you don’t utilise your full ISA allowance in a tax year, you can’t carry it forward. You also can’t replace it within the tax year if you make a withdrawal; for example, if you open an ISA and pay in your £20,000 annual allowance, and within the same tax year withdraw £5,000, you’ve made your maximum contribution of £20,000; you can’t replace the £5,000 into the ISA, even though your balance is now £15,000.
Pensions: The lifetime allowance for pension pots is currently £1.055m, and you’ll be taxed on any amount over this allowance.
ISAs: There is no lifetime allowance for an ISA; you are simply limited by the annual allowance.
Taxation on income
Pensions: When you withdraw from a pension, 25% is tax free and does not contribute towards your personal allowance. You are liable to pay income tax on the remaining 75%. How you pay tax depends on how you are withdrawing from your pension. You decide not to take the tax-free cash as a lump sum, but decide instead to make regular withdrawals from the full pension pot. Part will be taxable based on your marginal rate, but 25% will be tax free.
ISAs: All income from an ISA is tax free to the individual, although Stocks and Share ISA’s have dividend tax that the fund manager pays.
Pensions: If a family member inherits your pension upon your death, in certain circumstances (particularly if you passed away before 75) your pension falls outside your estate and will not be subject to inheritance tax. You can read more about inheritance tax and pensions here.
ISAs: Your ISA will form part of your estate for inheritance tax purposes and will be subject to 40% tax if you are above the nil-rate band.
When it comes to retirement planning in a tax efficient way, it’s rarely as simple as pensions versus ISAs, and which one scheme you should choose. As you can see from this overview, both have their advantages and disadvantages in taxation and flexibility. Often, establishing a plan that is most suitable for you is about finding a balance and using ISAs to support your pension savings.
The value of the investment can go down as well as up and you may not get back as much as you put in.
The value of pensions and the income they produce can fall as well as rise. You may get back less than you invested