In our last pensions versus ISA blog we explored the different options available to help with short-medium- and long-term savings here.
In this blog, we examine the relative benefits of using stocks and shares or lifetime ISAs (LISAs) and pensions to provide for your retirement.
Getting the best from the Taxman
The most important benefit from saving into pensions and ISAs is the availability of tax relief. Contributions to pensions are paid into your pot before you pay tax. This means you get a free top up of 20% from the government before you’ve even started investing. Higher rate taxpayers may get even more generous relief. In addition, you can withdraw 25% of your total pot tax free when you reach age 55 (this increase to age 57 from 2028). You only pay tax when you take the income on the remaining 75%. These generous tax reliefs make pensions one of the most efficient ways to save for retirement.
Contributions to ISAs are made after you’ve paid income tax, but you do not pay any tax on the investment returns and you don’t pay tax when you withdraw the money.
Lifetime ISAs receive a 25% contribution from the government each tax year. While this is a generous addition, the amount is not paid until the end of the tax year meaning the bonus does not attract growth for first 12 months.
And bear in mind, pensions are not subject to inheritance tax which makes them a great way to pass money to your relatives. ISAs, on the other hand, are included in your estate.
Knowing your limits
While there are significant benefits to saving for the long-term, there are limits on how much you can invest before you lose the tax relief.
You can pay 100% of your salary into a pension but tax relief is limited to £40,000. For ISAs the annual allowance as of the 2020/21 tax year is £20,000.
Anyone can save into a pension from any age and your family can make contributions on your behalf. This means it is possible to set up a tax efficient long-term savings vehicle for children and grandchildren. However, you cannot withdraw from your pension until age 55 without incurring notable tax penalties. You cannot save into a pension after age 75.
The rules are different for ISAs. You must be 18 to save into an ISA [although there are junior ISAs for under 18s]. For Lifetime ISAs, you must start saving before your 40th birthday and you can’t withdraw until you are age 60, unless you are using the money to buy your first property. In addition, you can only save £4,000 a year (About £333 a month) into a LISA.
Investment opportunity and risk
Pensions, stocks and shares ISAs and LISAs are all invested with the aim of making higher returns for you than if you were simply holding cash. Typically, your money will be invested in the stock markets investing in companies that give you a return through dividends. These are rewards for holding shares. Your money might be invested just in the UK or in other countries’ stock markets.
If you choose to invest in a self-invested personal pension (SIPP) - see link for more info - then you will likely have access to a lot of different ways to invest your money.
The important thing to remember is that while your money can grow it can also be lost. There is always a risk from investment and you should be sure you understand those risks before parting with any money.
The chart below shows how much you might have made by investing £100 in each of these options over 40 years.
What are the costs?
There are fees and charges to pay to the companies that look after your ISAs and pensions. There is usually an annual management charge (AMC) which varies from provider to provider. These should usually fall below 1% but it is always important to shop around.
You may also pay to withdraw money from an ISA early, and you will lose your tax relief if you take money out of a LISA unless it is after age 60 or to buy a first property.
You may also pay fees to transfer to a new provider.
Charges and costs might be buried in the small print, so be careful to read everything thoroughly before committing.
Which is best?
There is no right answer to which is the most suitable for retirement saving between an ISA and pensions since this must be decided based on what is best for you. However, if you are searching for flexibility then ISAs might be the best choice. For overall tax efficiency then pensions are best, so long as you can wait to access the money until you are aged 55.
The chart below gives you an idea of how much money your might have made on £100 invested over 40 years while the table shows what each option has to offer.
What do pensions and ISAs have to offer?
What would happen to £100 invested over 40 years
Source: Flying Colours and ii.co.uk[i]
[i] Notes: Chart assumes investment growth 6% pa; dividend income 3%per annum reinvested; tax on dividend income 20% per annum (taxable account);40-year investment; tax on pension withdrawals amounting to 15% (25% tax freeplus 20% tax on the balance). Capital gains tax (taxable account) not included.Source: Flying Colours