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Pensions or ISAs: What's best for your savings pot?

Chiara Cavaglieri and Julian Knight weigh up the flexibility and tax benefits of the alternative products

Chiara Cavaglieri,Julian Knight
Sunday 11 March 2012 01:00 GMT
Pensions are great because they offer the best chance to build up a nest egg with initial tax relief on your contributions
Pensions are great because they offer the best chance to build up a nest egg with initial tax relief on your contributions (AFP/Getty Images)

Individual savings accounts and pensions get a very different press. Whereas ISAs are widely seen as a bit of an investment no-brainer, shielding your savings and investments from tax, the word pensions is so often lumped together with the "crisis", "mis-selling" and "rip-off". But what is the truth? If there is a straight shoot-out between ISAs and pensions for your savings pot, where should you put it?

It's never been more apparent that as an investor, some things are out of our control – whether it's the direction shares might go, where lenders set their interest rates, or even which country is going to need bailing out next. One thing you can take into hand is sheltering as much money away from the taxman as possible, and while both pensions and ISAs have a lot to offer, ISAs seem to be winning the public over.

In a new National Association of Pension Funds (NAPF) survey this week, 54 per cent of employees said they are not confident in pensions compared to other ways of saving, marking a record low for the index. Figures from the Office for National Statistics also show that Britons put £15.8bn into stocks and shares ISAs and only £14.3bn into personal pensions. It's easy to see why ISAs have proved so popular – they are in many ways much easier to get to grips with than pensions. Investors put their money into an ISA safe in the knowledge that it is sheltered from income and capital gains tax (CGT) while still being accessible.

However, if you're specifically looking for income in retirement, David Penny of the independent financial adviser Invest Southwest says it is pensions all the way. "They are the most growth-efficient way of saving for an income in retirement. ISAs do not come close. The tax and growth efficiency is ever greater the higher the marginal tax rate of the contributor and the lower the marginal tax rate during retirement."

Pensions work in the opposite way to ISAs – so instead of making tax savings on returns, you get tax relief on your contributions. This means as a basic-rate taxpayer, an £80 contribution is worth £100 in a pension, and higher-rate taxpayers will gain even more; if you pay 40 per cent, an £80 pension contribution is still worth £100, but you can also claim another 20 per cent as a tax rebate on your self-assessment form. However, there are strong signals that higher rate tax relief on pensions may become a victim in the drive for austerity in this month's Budget. This will take away a major incentive for Britain's wealthier tax payers to save in a pension.

Overall, you can put in a maximum of £50,000 each tax year, but you are also able to go back to the previous three tax years and carry forward any unused relief.

Starting in October, the Government is asking employers to automatically enrol eligible workers into a qualifying workplace pension scheme. Although you can choose not to be enrolled, if your employer makes contributions into your pension, experts say to do so would be tantamount to refusing free money.

"Quitting a workplace pension can mean losing tax breaks and employer contributions which are, in effect, 'free money'. The benefits of auto-enrolment need to be more widely understood," says Joanne Segars, NAPF's chief executive.

Pensions may also be a better option in terms of paying inheritance tax, because while your pension is still invested, the pot will be passed on free of tax to your loved ones if you die – although after retirement, if you have purchased an annuity, any remaining money stays in the pocket of your provider unless you build in a costly death benefit for your partner. With an ISA, the money you have saved forms part of your estate, and will therefore have an impact on your inheritance tax liability.

Where pensions come unstuck, however, is on flexibility. With an ISA, you can access your money as and when you like (although there are comparatively short-term restrictions and interest-rate penalties on some fixed-rate cash ISAs). As a basic-rate taxpayer using a cash ISA this means avoiding the 20 per cent income tax that standard cash savings accounts carry, and if you've opted for a stocks and shares ISA, you can avoid paying 18 or 28 per cent CGT on any gains above the tax-free allowance (£10,600).

The ISA allowance is fairly generous and even better, rises with inflation, so this tax year you can deposit £10,680 (of which £5,340 can be placed into a cash ISA), and from 6 April, this will rise to £11,280.

With a pension, your money has to be left alone until retirement. This means waiting until you are at least 55 before you can touch your own money, and even then, only 25 per cent can be withdrawn as a tax-free lump sum, the rest must be used to provide a regular income. To make matters worse, annuity rates are currently very poor, and with people living much longer, there isn't any sign that they will improve.

With this in mind, Justin King, from MFP Wealth Management, believes that it is not worth locking your money away in a pension unless you're a higher-rate taxpayer.

"ISAs offer real flexibility and can always be converted into a pension contribution if you become a higher-rate taxpayer or a non taxpayer, which is very tax effective as well," he says. "ISAs offer ultimate flexibility in how you take the income; pensions are just deferring the eventual taxation."

For many people, pensions are simply too complicated. In comparison, ISAs are fairly easy to understand, and with the recent introduction of Junior ISAs, there is even greater scope for ISAs to be a successful long-term investment vehicle to rival pensions. Even for higher-rate taxpayers, government meddling with pension rules could be enough to put investors off; in the past few years they have increased the age at which you can access your pension from 50 to 55, and there is a chance that other changes are afoot which could make pensions even less appealing.

"If the Government takes higher-rate tax relief away in the Budget as rumoured, they could be sounding the death knoll for pensions, which would be a travesty, especially when everyone needs to be saving more for their futures," says Darius McDermott of Chelsea Financial Services.

Despite this, many experts argue that the best way forward is to combine the two and make the most of their separate benefits. For example, if you are basic-rate taxpayer right now, but expect to pay a higher rate in the future, an ISA can be used now and then transferred over to a pension when the time comes. Cash ISAs may also make a useful emergency pot – it is usually advisable to put away at least three months income as a rainy-day fund – as you can access the capital easily.

"Pensions and ISAs used in combination are very powerful methods for saving long and short term," says Minesh Patel of EA Financial Solutions. "Pensions are a good long-term investment and will provide a valuable foundation for income in retirement, but need to be managed carefully. I genuinely believe that ISAs are one of the most flexible methods of long and short-term saving."

Expert view

Darius McDermott, Chelsea Financial Services

"ISAs are a great savings vehicle as evidenced by people investing more in them than pensions last year. However, unless the rules are changed significantly, they won't allow people to save enough over their lifetimes to pay for all the high-ticket items they need (education, homes, retirement). We need pensions too."

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