Pension versus ISA
Introduction
This briefing sets out the factors to consider when looking to recommend a pension or ISA contribution.
Core considerations
- ISAs and pensions are tax-efficient and both should be considered for investment where this is affordable.
- Where a choice is to be made between ISA and pensions, generally a pension will provide the potential for a better return due to the tax treatment (ignoring any differences in charges or investment growth).
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Pension rules are generally more complex than ISAs.
- Currently pensions provide an Inheritance Tax shelter that ISAs do not.
- The amount of tax-free cash available from pensions is capped by the lump sum allowance or lump sum and death benefit allowance. ISAs are not capped.
- A client’s requirements to access savings, and at what age, may be critical in determining whether an ISA or a pension is chosen for an investment.
Contents
Investing and tax treatment
Invested funds in ISAs and pensions are both treated in a tax efficient way with no income tax or capital gains tax due on or in respect of the funds whilst they are invested. It is for this reason that ideally, where there is sufficient capital to invest, both an ISA and a pension should be considered together and before any other investments are considered.
Employer funding may be relevant – an employer can fund a pension directly but can’t fund an ISA unless acting as an agent for an employee contribution (which is an administrative function only with no benefits).
Tax treatment on entry and exit
Despite similarities on tax treatment whilst invested, the tax treatment on entry and exit is an area where there is significant difference between an ISA and a pension.
The maximum investment into an ISA is £20,000 a year and contributions to ISAs do not attract any uplift but pension contributions do. Note that Lifetime ISAs include a 25% government uplift similar to a pension, but this comes with some additional restrictions on the use.
For a pension the rules are more complex, personal contributions up to a clients net relevant earnings (or £3,600 if higher) attract tax relief. The annual allowance of £60,000 effectively caps tax relief as higher levels of contributions will be subject to an annual allowance tax charge. Carry forward may be used in some instances to increase that limit. Some clients may be subject to a tapered annual allowance or where clients have started to access benefits the money purchase annual allowance may apply.
Relief at source pension schemes receive basic rate of tax relief, even if the individual is not a tax payer, increasing the gross investment compared to an ISA. In addition, higher and additional rate tax relief may be applicable for pension contributions thus increasing the net salary received. Contributions to a net pay scheme result in less tax and higher net salary.
On exit usually up to 25% of the pension fund is payable free of any tax, capped by the lump sum allowance, with the remainder taxed as income. If pension funds are payable in the event of death before age 75 they are generally paid free of any tax although any lump sum payment in excess of the lump sum and death benefit allowance will be taxable as income in the hands of the beneficiary(ies). On death after age 75 all pension benefits are subject to income tax.
All funds drawn from an ISA are free from income tax without any cap.
Access considerations
Age considerations are relevant, both in terms of paying into and taking money from either investment. There is no minimum age for a pension investment but there is a minimum age for an ISA (18 for stocks and shares, 16 for cash) however a Junior ISA can be used instead for children.
There is no maximum age for an ISA investment but pensions contributions no longer benefit from tax relief from age 75. Some pensions may still end at age 75 though this is no longer a requirement, so some pensions can continue until needed or can be left as death benefits.
Access is a critical factor in that ISA funds can be accessed at any time, but pension funds can only be accessed (unless on ill-health terms or on death) from age 55 (rising to age 57 in April 2028). Clients that anticipate a need to access funds before the minimum pension age may benefit using an ISA or a combined strategy.
Clients that opt for a Lifetime ISA can access the ISA at any time but suffer a 25% charge if drawn before age 60 unless used to purchase your first home.
Inheritance Tax (IHT)
IHT planning may be a factor when deciding whether to invest in an ISA or a pension. Funds in an ISA are assessable for IHT purposes, but pension funds are generally not currently assessed for IHT. There are a number of circumstances when a pension can be subject to IHT, see our briefing on Pensions and IHT.
In the Autumn Budget 2024 the Government announced a consultation to bring all unused pensions and pension death benefits into assessment for inheritance tax from April 2027.
Comparisons between pension and ISA
A mathematical comparison reveals that, taking into account the differences in tax treatment on entry and exit, an investment into a pension will deliver a better net result than the same investment into an ISA. For a lifetime basic rate tax-payer the difference in net returns is 6.3% in favour of a pension.
Where a client can only fund one of either an ISA or a pension a balancing act is required to determine what is the right route to take. The mathematics point in the direction of a pension but the client’s objectives (particularly in relation to access to savings or the complexity of a pension) may mean that a pension is discounted in favour of an ISA despite the potential of a lower return overall.
Many employed clients will also be enrolled into a pension scheme where their employer also contributes, so when employer contributions are factored in this can make the returns from a pension more favourable.
Summary of differences
Issue | ISA | Pension |
---|---|---|
Maximum contributions | £20,000 a year | Net relevant earnings/£3,600 or annual allowance |
Employer funding | No | Yes |
Tax uplift on entry | No | Yes, even for a non-tax payer |
Tax due on exit | No | Yes on 75% of the fund drawn |
IHT assessable | Yes | Not currently |
Minimum investment age | 16 (cash) 18 (stocks and shares) |
None |
Maximum investment age | None | No tax relief after 75 |
Access restrictions | None | Not before 55 (rising to 57) |
Example
Robin and Maurice are 55-year-old twins and are both looking to invest £20,000. They are both higher rate tax-payers but are likely to look to access their savings in 10 years’ time. Robin invests his £20,000 in an ISA but Maurice decides to invest in a pension instead. Over the 10 years invested the funds achieve growth of 3% per annum net of charges. Both are now basic rate tax-payers and take their funds as a lump sum. Basic rate tax assumed at 20%.
Consideration | Robin's ISA | Maurice's pension |
---|---|---|
Amount invested | £20,000 | £25,000 (with tax relief) |
Amount available after 10 years (including 3% per annum net growth) |
£26,878 | £33,598 |
Tax payable | None | £5,040 |
Net amount payable after tax | £26,878 | £28,558 (6.3% higher) |
Maurice also received an enhancement to his income as a result of higher rate tax relief on the £25,000. However, if the taxable income (75% of the pension) for Maurice pushed him into a higher tax bracket then the advantage could be lost. Drawing the pension over multiple tax years can help to mitigate higher rates of tax.