Saving for the future is more important now than it has ever been. People are living longer and the cost of living is edging ever higher. One great way to ensure that your savings perform as well as possible is to take advantage of certain savings vehicles such as a pension or ISA which both offer tax benefits for savers. In today’s article we will be considering whether it’s the pension or ISA that is better for savers.
What Is A Pension
Pensions are designed specifically to help individuals save for retirement. Savers are able to save a relatively small amount of their income on a regular basis across their working lifetime. That money is then invested in different assets depending on the risk profile of the individual with the aim of increasing the overall value of the savings and then when the saver eventually reaches retirement age the money can be distributed to them to fund their retirement. Money saved within a pension cannot usually be accessed until the individual is at least 55 years old although this varies by scheme.
Types Of Pension Schemes
There are different types of pension schemes available to savers and which one you would pay into will depend on your personal circumstances.
Most people will be a member of one of the following:
- Occupational pension – Established by an employer to provide benefits to employees. An occupational pension scheme could be a defined benefit scheme where the benefit you receive on retirement is based on your earnings and length of service with your employer (sometimes referred to as final salary). Alternatively it could be a defined contribution scheme where the benefit you receive on retirement depends only on the value of the pension pot at retirement date.
- Personal pension -This type of pension is usually for individuals who are not in employment, are self employed or who want to save outside of their employment. A personal pension plan will be a defined contribution scheme so the benefit on retirement is based on the value of the scheme at that date. Essentially the more you contribute to the pension and the better your investments perform the more money you will have on retirement.
Tax Benefits Of A Pension
By saving your money in a registered pension (one that is registered with HMRC) you will enjoy a number of tax benefits that will give your savings a boost. Those benefits include:
- Tax relief on the individuals contributions – HMRC are often able to give tax relief on contributions made by the individual, usually up to the equivalent of 100% of the individuals earnings or £3,600 whichever is higher. Tax relief is usually given at the individuals marginal rate of tax so if you are a higher or additional rate tax payer then you can benefit from 40 or 45% tax relief. This means that an additional rate tax payer who want’s to add £100 to their pension pot can often do so by contributing as little as £55. Those who make large contributions should be cautious of the “annual allowance charge” which can result in an additional charge to the taxpayer but this only usually applies where contributions exceed £40,000 in a tax year. You can learn more about this subject by completing the accompanying course from The Accounting & Tax Academy.
- Investments within the pension are able to grow tax free – Any return that investments within the pension generate are usually free from capital gains and income tax.
- Tax free lump sum – When withdrawing a pension a 25% lump sum can be withdrawn tax free whilst the remainder will be subject to the usual income tax rules which may or may not result in tax being payable depending on personal circumstances. (Savers should be aware of the lifetime allowance which can result in an additional tax charge for those with large pension funds).
- Not included as part of estate for IHT – The value of a pension scheme is not usually considered as part of an individuals estate for inheritance tax purposes.
What Is A ISA
An individual savings account is another tax efficient vehicle to house your savings within. The ISA is not specifically designed for retirement savings but is perfectly suitable for this job. The ISA offers savers more flexibility and easier access to their money as some types of ISA will allow you to access you money with little or no notice. The saver can choose between different types of ISA to suit their needs and risk appetite.
An individual has an ISA allowance of £20,000 (21/22) per tax tax year. They can save this amount in1 type of ISA or spread it across a number of different ISA types but an individual cannot pay money into 2 ISA’s of the same type within the same tax year.
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Types Of ISA
There are a number of different types of ISA’s available to suit the different needs of savers. These include:
- Cash ISA – Similar to a savings account except any interest received in free from tax. Due to record low interest rates this type of ISA is currently unpopular with savers but as savings rates increase it becomes a more attractive option as it is extremely low risk.
- Stocks & Shares ISA – Savings are invested into listed stocks and shares. Any income generated by those investments is free of tax. This includes dividend income which usually falls under income tax rules and any capital gains which falls under capital gains tax rules.
- Innovative Finance ISA – Involves your savings being used to provide peer to peer loans. This is a less well known ISA and generally less popular with savers.
- Lifetime ISA – Savings could be in the form of cash or stocks and shares or a combination of the two. The lifetime ISA shares a similarity with the pension in that contributions can benefit from tax relief however an individual con contribute a maximum of £4,000 per tax year into a lifetime ISA and tax relief is only at basic rate which means a maximum of £1,000 tax relief can be achieved each tax year. The lifetime ISA offers less flexibility as to keep hold of the tax relief savings must remain in the ISA until the age of 60. The £4,000 lifetime ISA allowance is considered part of the overall £20,000 allowance so once £4,000 has been paid into a lifetime ISA the individual would have £16,000 allowance remaining for other ISA types.
Tax Benefits Of An ISA
Just like pensions, any savings held within an ISA can also enjoy a number of tax benefits but they differ slightly from saving within a pension. The key tax benefits include:
- Tax relief on some contributions – only savings in a lifetime ISA attract tax relief on the individuals contributions. Contributions to this type of ISA are capped at £4,000 per tax year and tax relief is given at the basic rate of tax.
- Investments held within an ISA are able to grow tax free – Any return that investments within the ISA generate are free from capital gains and income tax. The treatment is identical for a pension or ISA’s.
- Tax free withdrawal – 100% of savings held in an ISA can be withdrawn tax free. There is no cap on how large an ISA can grow and how much can be withdrawn although savers should be aware that any early withdrawals (before 60 years of age) from a lifetime ISA will result in a 25% charge which is HMRC recovering the tax relief they originally gave.
- ISA balance passes to spouse/civil partner – The value of an ISA is considered part of an individuals estate for inheritance tax purposes but if passed to a spouse or civil partner on death, the spouse/civil partner will benefit from a one off increase in their ISA allowance equivalent to the value of the inherited ISA. This means that not only do they inherit the ISA but also the ISA’s tax free status.
Which Is Better Pension Or ISA?
- How long you are happy to tie up your money for? A pension is typically a longer term commitment.
- The reason you are saving (house, car, retirement) An ISA is usually more suitable for those saving for cars, houses etc.
- The highest rate of tax you pay (the more tax you pay the more of an impact tax relief can have on your savings, in particular when making pension contributions).
- Are you already contributing to a pension or ISA? If so you should be cautious of annual & lifetime allowances. If you are approaching one of these allowances it will usually be beneficial to use a different savings vehicle and avoid any potential charges.