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Pension or ISA – What is the best way to save for long term planning?

Pension:

Pensions provide the most tax efficient saving option. Contributions into a pension receive tax relief at the same rate you pay income tax, meaning the value is higher immediately, which will lead to higher returns than an ISA on a like-for-like basis.

This means that for higher rate taxpayers, a contribution of £10,000 will only cost £6,000 after tax relief and for those on the additional rate of tax the net cost of a contribution will be £5,500. In addition to this, you can receive tax free cash on up to 25 per cent of the fund available when you are taking benefits. The annual saving limit for the majority of savers is also £40,000 – significantly higher than the ISA limit of £20,000.

Let’s consider an individual saving £10,000 into an ISA, and the equivalent amount into a pension. Assuming a 6 per cent annualised rate of return net of costs for both, the ISA value would be £17,908 after 10 years, and £32,071 after 20. 

However, a higher rate tax payer subscribing £10,000 into a pension will see it get topped up by basic rate tax to £12,500 and in addition, will receive a £2,500 

tax credit. Based on the same timescale and return assumptions, the pension would end up with a higher amount of £22,386 after 10 years and £40,089 after 20 years, but with an initial net investment amount of £7,500. In this scenario the higher rate tax payer would end up with an extra £8,018 return over 20 years, for £2,500 less cost. In addition, should the £2,500 tax saving be invested, this would increase the investment savings further.

How funds can be accessed from a pension may have been off-putting to savers previously, however, since pension freedoms was introduced, savers are able to take income or a lump sum as and when required after the age of 55.

Investing into a pension can also be beneficial from an estate planning point of view as money purchase pensions are outside of the estate meaning that they are a highly efficient method of passing on wealth. In comparison, in most cases an ISA remains within the estate for Inheritance Tax purposes.

Investing into a pension can also be beneficial from an estate planning point of view in the event of death. An ISA fund will form part of the estate for Inheritance Tax, however with a pension the benefits paid on death do not normally form part of the investor’s estate. With the new pension flexibility, this means it is also possible to pass the funds down through the generations while keeping the funds invested in a tax efficient beneficiary’s pension plan.

ISA:

Investing into an ISA is the most flexible option for investors. When taking benefits from an ISA all of the proceeds are tax free whereas the income from a pension is taxable.

Pensions have become much more accessible in recent years but they do not provide the level of access flexibility as ISAs. This is because savings within the ISA wrapper are available at any given point in time, rather than from age 55 within a pension. This can be a reason to choose the ISA option as the funds are available to be used for a wide range of future objectives such as paying off a mortgage, funding the costs of education or having access to tax free capital needs in addition to income requirements during the retirement years.

Pensions are subject to the Lifetime Allowance tax charge should the value exceed this on crystallising the funds. The Lifetime Allowance in the 2018/2019 tax year is £1,030,000 with any excess funds above this taxed at 25% if taken as income or 55% if taken as a lump sum. Unlike a pension, an ISA has no upper limit on the amount that can be accumulated in them. 

There have been changes to the amount you can pay into your pension on an annual basis before an Annual Allowance tax charge is made. The recently introduced tapered allowance for high earners can mean that the £40,000 allowance can be reduced to £10,000 which is something to bear in mind when making contributions.

Finally, an ISA could be beneficial to basic rate tax payers should they utilise the governments Lifetime ISA. 

The decision between a pension, ISA or both will ultimately depend on your individual circumstances, and in many cases a combination of ISAs and pensions should be used together as part of your future planning

If you are interested in finding out more about how Pensions and ISAs can help as part of your long term planning, please get in touch with Martin Brown on 0151 348 8440 or email mpb@mocomoney.co.uk and I will be pleased to help.