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There are at least two ways to control your investment growth – the fees you pay, and taxes. For the latter, two investment vehicles are popular for retirement planning – pensions and ISAs (i.e. individual savings accounts). Which is better for mitigating unnecessary tax and enjoying more of your hard-earned savings in later life?
Outlining the contenders
It’s important to recognise that pensions and ISAs deal with tax in different ways, which can be key when deciding between them. In the former case, the UK government offers tax relief on your pension contributions at your rate of income tax. With a workplace pension this is usually dealt with automatically under auto-enrolment rules (via PAYE). For instance, a Basic Rate taxpayer would get 20% tax relief on their contributions in 2020-21, meaning it “costs” only 80p to put £1 into your pension. For a Higher Rate taxpayer, the relief is 40% leading to a 60p “cost”.
With a pension, however, the income you take from it when you retire is subject to tax. In effect, therefore, by contributing to a pension you are deciding to be taxed later (when you may well be in a lower tax bracket than during your career). For an ISA, however, you tend to put income in after it has been subject to tax – e.g. savings which come from your post-tax salary. Yet once the money is in the ISA, all interest and investment returns (capital gains and dividends) are free of any tax. As such, this approach to retirement saving involves getting taxed at the beginning. You can put up to £20,000 per tax year into your ISAs.
Choosing between the two
Given this tax arrangement, choosing between an ISA and pension will be partly influenced by your income now – and that which you expect to generate in retirement. A Higher Rate taxpayer on £60,000 per year, for instance, may be attracted to putting, say, £9,000 into a pension. This is because the £9,000 would receive 40% tax relief, whilst putting it into an ISA would mean a 40% tax hit (even if the money is then shielded from tax). A Basic Rate taxpayer, however, may have a more difficult decision to make. Yes, putting the money into a pension means 20% tax immediate relief on the contributions, yet their future retirement income is unlikely to enter the Higher Rate tax bracket (i.e. subject to 40% tax).
At least two other factors are at play, however. Firstly, when do you hope to retire? In 2020-21, the earliest you can retire with a workplace/private pension is 55 – set to rise to 57 in the future. An ISA, however, has no restriction on when you can withdraw the money, making it attractive for those seeking early retirement. Secondly, how much do you expect to save for retirement? Under current pension rules, the maximum you can save into your pensions is £1,073,100 (i.e. the “lifetime allowance”). If you expect to exceed that amount, then you may need to turn to your ISA where there is an annual limit (£20,000) but no total cap on how much you can save.
As we conclude, it’s worth stating that ISAs and pensions are not mutually exclusive. Indeed, it can be valid to use both in a retirement strategy. For instance, suppose you hope to retire early at age 55, in the future. Under existing rules, this would mean generating retirement income outside of your state pension and workplace/private pensions. As such, for the initial years of retirement you could lean more heavily on ISA savings and perhaps other income streams (e.g. rental income from tenants). As you progress through retirement and your pensions become available to use, these channels could then start to be opened up to fund your lifestyle.
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