Latest News › ISAs versus Pensions

The avoidance of taxes is the only intellectual pursuit that still carries any reward.

John Maynard Keynes

Pensions have long been seen as the main route to generating an income in retirement, but their inflexibility and complexity can be frustrating. One of the most important problems with pensions is that it forces investors to do certain things with their accumulated pot when they retire. Until relatively recently, it forced them to buy an annuity at 75. Now they have the choice of an annuity or drawdown products, but flexibility is still limited. This has led many investors to consider alternative retirement solutions, notably the use of Isas.

Some of this shift is based on purely mathematical considerations. Pensions’ investors get tax relief on the way in, but pay tax on any income generated from a pension after retirement (after the 25% tax-free lump sum has been used). Isas do not provide any tax relief on the way in, but any income generated is tax-free. The decision is, therefore, partly a simple calculation on tax relief on the way in versus taxation on the way out.

If someone is a lower rate tax payer, but has accumulated a large company pension, for example, and is likely to be a higher rate tax payer in retirement, Isas look like the better option. If someone is a higher rate tax payer and receives 40% or 50% tax relief on their contributions, but is likely to be below the higher rate threshold in retirement, pensions will look the better option.

However, it is not an entirely economic calculation. In spite of the much-heralded pensions’ simplification legislation in 2006, pensions have remained subject to government whimsy. Complex rules were introduced in the last budget of the Labour Government and have been kept in place by the Coalition. Successive governments continue to change the rules on how much can be held within a pension, contribution limits and retirement age. For example, as it stands, investors cannot take their cash before 55, but there are no guarantees that this will not be extended by future governments.

Isas, in contrast, have been relatively untouched. Contribution limits have been regularly and steadily extended and the concept has been more broadly adopted with the advent of Junior Isas. Certainly, they are not as vulnerable to governments tinkering with the rules because investors can simply withdraw their money. With pensions, there is no way out until retirement.

Equally, the tax-free income from Isas does not have to be declared, it has no impact on age-related allowances and, perhaps more importantly, it is entirely flexible. Investors can take it when they like and can take as much or as little as they like in any given year.

Of course, pensions have some advantages. The contribution levels are far higher – £50,000 for 2011/2012 versus £10,680 for Isas. There is also the advantage of employer contributions.  Employers will often match employee contributions, helping investors generate a bigger pot at retirement. Equally, with the advent of Self-Investment Personal Pensions (Sipps) the investment flexibility of pensions has improved significantly.

For most investors, it has to be said, it will not be a case of either one or the other. Both have their place in a portfolio and enable investors to maximise the amount of money held in tax-efficient wrappers.

Posted on 04 Nov 2011