ISA vs. Pension: What Should You Choose for Retirement Savings?

ISA vs. Pension is a very crucial question because your retirement pool can be hugely affected by the method you choose for saving. Due to the power of compounding, even a 1% difference in interest rate, for a sum of £5000 per month invested over a 30 year period could amount to more than £600,000. That is the total amount of money that an average UK retiring couple spends between age 65 and 85, based on the research by Chris Evans, chief executive of pension expert MGM Advantage. That means just by choosing the right method of saving and with no other extra effort, you can have that condo or the car you always desired, or the Ivy League college education you dream for your kids.

Pension vs. ISA Basics

Pension	ISA
£40,000 annual allowance	£15,240 annual allowance
Tax free contribution	Contributions from taxed income
£1.25 million lifetime allowance	No lifetime limit
Marginal-rate tax relief added to your contributions	No tax relief at the time of contributions
Funds grows free of income or capital gains tax	Funds grows free of income or capital gains tax
Pool can be accessed after 55 years of age	Pool can be accessed any time
25% tax free lump sum can be withdrawn; Further withdrawals taxed at marginal rate	Withdrawals free of tax
Inherited free of tax if you die before 75	Can be passed on to your spouse

How to choose between ISA and Pension

The answer is ISA. No it’s pension. No, no its ISA. Do you think the answer is that simple? In fact, like all good things you need to dig a little deeper to get to the treasure.  There is no one universal answer that can be applied to every UK citizen for a choice between an Interest Saving Account and a Pension Scheme. The answer depends on your age, level of income, capacity of risk taking, savings, and what you plan to do after retirement. Sounds way too complicated. There is an easier way to make a sense out of it. Meet Maria and Rob. Maria is a vivacious girl in her early 30s. She is a marketing manager with Publicitas and makes around £60,000 annually. She doesn’t have much in the way of existing savings but after incessant nagging from her dad wants to contribute 20% of her income towards saving. On the other hand we have Rob. Rob is a family man in his mid-40s. He is a neurologist with London Bridge Hospital and makes around £200,000 annually. He has a wife and 2 teenage daughters. He has an existing savings pool of £100,000 and can contribute only 5% of his income towards saving. In fact, many people in UK now have an investment pool greater than £100,000 and that qualifies them to have a wealth manager. Let’s help Rob and Maria decide what choice they should make.

Source: Telegraph.co.uk

Case Study 1: Maria (age<35 yrs, salary<£150,000, no savings)

Maria wants to contribute 20% or £1000 per month towards savings. But the important thing for her to understand is that, if she contributes it towards pension, the pool would be inaccessible before the age of 55. If she wants to access before it due to an emergency, she would have to pay a monstrous 55% penalty tax. As Maria has little in the way of savings, it would be advisable to go with an ISA for now. She should build up savings worth 6 months of salary in an ISA and then go ahead with contributions towards Pension Funds. But would Pension fare out better than ISA? Let’s check.

As the contribution towards Pension is tax-free, saving £1000 per month would be effectively equal to investing £600 in an ISA (at marginal tax rate of 40%). Thus, at the end of the year her total Pension contribution would be £12,000 whereas her ISA contribution would be £7,200. Let’s say both the contributions were invested in funds which offered the same interest rate and doubled in 20 years, with Pension pool at £24,000 and ISA pool at £14,400. Her pension withdrawal would be 25% tax-free (£6000) and let’s assume the remaining would be taxed at the basic-rate tax band (20%) and comes to £14,400. Thus, the total comes to £20,400 (£6000+£14,400) whereas ISA pool, which is not taxable at withdrawal, is at £14,400. Thus, Maria would earn £6,000 more from investment in Pension. But these calculations depend on the fact that the entire money is withdrawn in one go and Maria still falls in the basic-rate tax band on Pension withdrawal.

Case Study 2: Rob (age 35-60 yrs, salary>£150,000, >6 months income saving)

Rob already has a safety net of £100,000 (equal to 6 months income) and but can contribute only 5% or £1000 per month towards savings. As he has lesser time than Maria for his retirement, he should be serious about building a pool to support 30 years of retirement. Rob falls in the higher tax bracket at 45% marginal rate and savings of £1000 per month in Pension, would approximately equal to £5500 in ISA. At the end of the year, his total Pension contribution would be £12,000 whereas ISA would be £6,600. Assuming doubling of sum, ISA pool available for withdrawal would be £13,200 whereas pension pool would be £24,000. In a similar fashion as above Pension pool withdrawal after tax would be £20,400. So, Rob would earn £7,200 more from investment in Pension, which is higher than Maria as he gets a higher tax relief on Pension. Thus, higher the tax bracket, the higher is the incentive to invest in Pension over ISA, provided you still fall in the base-rate band on Pension withdrawal. In fact the benefit can be defined as the original tax-relief rate minus 75% of tax-rate band on withdrawal.

ISA and Pension complement each other

From the above, we can gather that your tax rate bracket at the time of pension withdrawal plays a significant role in determining how much savings you would have from Pension funds. As Rob was in the higher tax bracket while in his 40s, it is unlikely that he can sustain his lifestyle with an annual income of less than £32,000 (income level for base-rate tax) post retirement. At this point of time, it makes sense for him to withdraw the remaining portion from his ISA savings as they are not taxable. Moreover, you can leave your pension pool to grow for a longer period of time. In such a case, Pension and ISA complement each other and it makes sense to make contributions towards both of them.  Also, in case Rob exhausted his pension quota of £1.25 million which includes investment growth, any further savings in pension would be taxed at 55%. If Rob enters the enviable position of hitting the limit of lifetime allowance, it would make more sense for him to start redirecting his contributions towards his ISA. In fact, as per Andrew James, head of retirement planning at wealth management firm Towry, “Because ISAs have been around for a long time, you see people with a lot of money sitting in them. You could be building up a really big pot of money, especially if both you and your spouse are doing it. In October 2014 Barclays Stockbrokers alone had 63 ISA millionaires.”

Source: Turkishweekly.net

What is better for Inheritance Planning

From 2015 onwards, pensions have become an effective way to transfer your wealth to your children or next of kin after your death. If you die before the age of 75, Pension funds can be passed on free of tax to your heirs. However, if you die after 75, income from pension would be taxed at the beneficiary’s marginal tax rate and lump sum withdrawal would be taxed at 55%. Whereas ISAs can only be passed to your spouse tax-free and if you want to pass it your children or your next of kin, it is considered a part of your estate. And as per the inheritance tax threshold anything above £325,000 (£650,000 for couples) would be taxed at 40%. So, from an inheritance perspective you can make contributions of £325,000 in your ISA post which you should redirect towards Pension.

So how should you finally manage both ISA and Pension

After hearing the stories of Maria and Rob above, we can gather there is no one correct choice between Pension and ISA. As you are beginning in your career, you should begin contribution towards an ISA and build a sufficient pool of 6 months to 1 year of your income. Post that as you grow older, your contribution towards your pension should increase. At the time of withdrawal of pension funds, you can withdraw the tax-free 25% lump sum and keep drawing income from the remaining amount. You can leave the taxable pension pool invested for some time to grow and keep drawing from your ISA pot to reduce your tax rate. This also demands that you have a significant ISA pot at the time of retirement. The pension lump sum and ISA pot within the inheritance threshold can also be passed to your next of kin. The actual amount of contribution towards ISA and Pension varies a lot depending upon your personal situation, so it is important to act now and discuss these options with your wealth adviser.

Know all about the Impact on your Pension from Budget 2016

Source: theguardian.com

On March 16, 2016, Chancellor George Osborn carrying his iconic red briefcase presented Budget 2016 to the parliament announcing sweeping changes to the pension industry yet again. In the past 4 years, the UK government has made some major changes to the pension ranging from auto enrollment in employers pension contribution to introduction of tax freedom most recently. And the Budget 2016 was no different in announcing interesting options for millions of UK retirees.

Introduction of Lifetime ISAs (LISA) for people below 40

In order to enable the young people to save more, Osborn has come out with Lifetime ISAs. From George Osborn’s Budget 2016 speech, “My pension reforms have always been about giving people more freedom and more choice. So faced with the truth that young people aren’t saving enough, I am today providing a different answer to the same problem…. for those under 40, many of whom haven’t had such a good deal from the pension system, I am introducing a completely new flexible way for the next generation to save. It’s called the Lifetime ISA. Young people can put money in, get a government bonus, and use it either to buy their first home or save for their retirement.”

Main features of Lifetime ISA

1. UK citizens between 18-40 years of age can open a LISA and invest a maximum of £4,000  annually
2. The government will provide bonus £1,000 annually in that account, until the age of 50
3. For every, £4 added by you, the government adds £1 on top of it
4. The savings pool can be used to buy property worth £450,000 or for retirement at age 60
5. Withdrawal for any other purpose or before 60, would remove the government bonus and 5% penalty tax would be levied
6. LISA contribution would count towards annual ISA limit, which has been increased from £15,000 to £20,000 annually.

Lifetime ISA seems like a great alternative for young people who are looking to buy homes or find a saving method which is not taxed at retirement. However, it may interfere with the Workplace Pension Plan as low earners might not have sufficient money to make contribution to both. If you have surplus income, figuring out how much to invest in Workplace Pension and Lifetime ISA can be a challenge. It will depend on your age, actual income, marginal tax-rate slab as it will determine the pension-tax relief, income at retirement which will determine the tax on lump sum pension withdrawal, annual limits on LISA and Pensions and can be better advised by a personal wealth manager.

A reduction in Salary Sacrifice Benefits for the high income earners

Source: www.emtax.co.uk

With this measure, the chancellor is especially targeting the highly paid executives. Salary Sacrifice is a very popular scheme with the higher income earners, as it allows them to pay for benefits like insurance, company car, childcare, pension and others from pre-tax income and the reduction in income leads to lower taxes. In fact, the UK government has noted that there has been a 30% increase in Salary Sacrifice schemes since 2010 and it is hurting the government’s treasury. The employee gets an equivalent pension contribution from the employer in return for salary reduction. In this manner, not only the employee saves on taxes but also gets a 1% saving in National Insurance Contribution (NIC). However, the real benefit comes from the saving of 13.9% on employers NIC.

The government is mulling a reduction in these schemes because according to some experts the total removal of this scheme would add a staggering £1billion per annum in government’s kitty. Although, the government hasn’t stated clearly how it plans to reduce the benefits, it will become clear as specific measures are announced by April 2017.

A Pension advice allowance to encourage people to plan for pension

Source: www.ijcrcps.com

Are you putting off taking pension advice due to high cost? Chancellor Osborn has heard your predicament in Budget 2016. The government has realized that expert advice is important for pension planning and has introduced a tax free pension allowance of £500. This will allow members of Defined Contribution pension schemes to withdraw £500 tax free from their pension pot before the age of 55 to pay for financial advice. In fact, it would not be a bad idea to take advantage of the Budget 2016 to plan your investments for the year.

Introduction of a Pensions Dashboard for the tech savvy

Source: Getty Images

On an average, a UK citizen changes jobs 11 times till his/her retirement age. This would mean a person needs to keep a track of 11 different pension pots to know their final pension income at retirement. This problem has been addressed in the Budget 2016. In an era of smartphones and drones, the government has realized that the pension industry is due for a technological upgrade. The Chancellor have announced the setting up of a Digital Pension Dashboard by 2019 where a retiree can track his pension from all different sources and view his retirement savings at one place. However, the Chancellor has asked the pension industry to develop and fund this dashboard. At this point of time, it looks like a difficult task for the different companies to work together to make this operational by 2019. But let’s not lose our hope so early, as some of these services already exist in the market in one form or another.

How will the Budget impact the tax you pay?

Source: BBC

You will get some relief from the taxes this year, as the income tax slabs have been increased. The personal allowance (income level after which you start paying taxes) has been increased from £11,000 currently (starting 1^st April, 2016) to £11,500 from April, 2017. This change will help you reduce tax by £180 per year. The 20% tax slab will increase from the current £43,000 (since 1^st April, 2016) to £45,000 beginning April, 2017. The income slab for the 45% tax bracket remains unchanged at £150,000. The future holds more in terms of tax relief for the lower income tax payers. The Conservatives have promised to increase the slab for personal allowance to £12,500 and the slab for 20% tax rate to £50,000 by 2020-21.

Green signal to Budget 2016 from Pension perspective

Overall, the Budget 2016 was a positive from pension perspective. The positive changes like Pension Advice Allowance, Pensions Dashboard, increase in Income Tax Slabs and to some extent Lifetime ISAs are a cause to cheer about. Lifetime ISAs do have some conflicts with the Automatic Enrollment policy in Workplace Pension plan and only time will tell if LISA has complicated savings for people or benefited them. Reduction in Salary Sacrifice is the only negative and its impact can only be judged after the finer details are sorted out by April 2017. Do consult your wealth advisor in case you want to plan for it in advance.