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withdrawn; Further withdrawals taxed at marginal rate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.
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