When you think about long-term saving, there are probably two things that jump to mind – pensions and Individual Savings Accounts (ISAs). I’m going to look at the differences between an ISA and a Pension to answer all your questions.
There are a lot of things to consider when choosing between a pension or an ISA. Both options have a variety of pros and cons so it’s important to take some time to properly think about your options.
If you want to build up your money in a tax-efficient way and want to know more about the best way to save, read on to find out everything you need to know.
- The main difference between a pension and ISA is the tax benefits – With ISAs you don’t pay tax on any interest earned. Pension drawdowns are taxed at your current rate.
- If you withdraw money out of a pension or SIPP this will be taxed, with the exception of the first 25% of your total pension pot, which you can withdraw without paying tax.
- Saving into a pension as a basic rate taxpayer will get you a 20% top up from the government.
What is an ISA?
An Individual Savings Account, or ISA, is a type of account that you can use to build your wealth. There are several types of ISAs on offer, so you may want to think about which is best for you.
There are also a variety of different providers to choose from. That’s why you may want to read my guide on the best stocks and shares ISA providers, so you can find the one that’s right for you.
What types of ISAs are available?
If you want to open an ISA, there are several different types to choose from. Some of the most popular ones are:
Cash ISAs are one of the most common types of ISA and, as the name would suggest, allow you to save in cash. Due to the tax rules of ISAs, any interest your money earns will be tax-free.
Since you are saving in cash, these accounts tend to be highly flexible, as you can access your money at short notice.
Stocks and Shares ISA
These are another popular type of ISA which allow you to invest your money instead of holding it as cash. This means that it can potentially grow more effectively.
However, it’s important to remember that investing your money also exposes it to risk. This can mean that you could potentially lose money if you aren’t careful.
- The number one choice for stocks and shares ISA
- Open an ISA account for £9.99
- Contribute as little as £25 per month
Important information - investment value can go up or down and you could get back less than you invest. If you're in any doubt about the suitability of a Stocks & Shares ISA, you should seek independent financial advice. The tax treatment of this product depends on your individual circumstances and may change in future. If you are uncertain about the tax treatment of the product you should contact HMRC or seek independent tax advice.
Lifetime ISAs have the dual purpose of helping people aged 18 to 40 to either save towards buying a first home or make a start on their retirement savings.
These have a lower annual allowance (more on this later) of only £4,000 each tax year but the government will top up your contributions with an additional 25%. This means if you save the full £4,000 into your Lifetime ISA, you’ll receive an extra £1,000 of essentially free money.
Of course, it’s important to bear in mind that you can only access the money in your Lifetime ISA when you come to buy your first home, or at the age of 60, without incurring a penalty.
Innovative Finance ISA
This type of ISA allows you to essentially loan your money to individuals and businesses who are looking to borrow. This can potentially result in strong returns but also comes with a significant amount of risk.
Not only is there the chance that the borrower defaults on their loan, but the lending platform may also go bust. Furthermore, it’s important to bear in mind that this type of ISA is not covered by the Financial Services Compensation Scheme, unlike Cash ISAs.
How much can I pay into an ISA?
Because ISAs allow you to earn tax-free returns, there is a limit to how much of your money you’re allowed to save in them.
Each tax year, from 6 April to 5 April, you can save up to £20,000 into your ISAs. This is known as your “ISA allowance”.
Of course, it’s important to bear in mind that however much of your allowance you have left, you can only contribute £4,000 into a Lifetime ISA each financial year. This is because of the lucrative benefits that they offer.
What are the tax benefits of saving with an ISA?
One of the main benefits of saving with an ISA is that they are a tax-efficient way to grow your wealth.
This is because any interest or returns are paid free from Income Tax or Capital Gains Tax. As a result, your money can grow much more effectively.
As you may know, your personal savings allowance allows you to earn tax-free interest on your savings. This stands at £1,000 a year if you’re a basic-rate taxpayer and £500 if you’re a higher-rate taxpayer.
If you have enough money that your interest goes over this threshold, an ISA can be a great way to avoid having to pay tax on it.
Another useful benefit of saving in ISAs is that your money is protected by the Financial Services Compensation Scheme. This means that if your ISA provider collapses, up to £85,000 of your wealth is protected per provider.
Are there any downsides to an ISA?
One of the main downsides to saving into an ISA is that it can sometimes be difficult to access your money if you need it at short notice. For example, if you have a stocks and shares ISA, there may be a delay as your assets need to be sold first.
What is a pension?
As you may know, a pension is a pot of your money that you put aside for your retirement. You invest this wealth, give it time to grow, and then when the time comes to stop working, it can support you.
To encourage people to save more for the future, the government also offers lucrative incentives, such as tax relief, when you make pension contributions.
Typically, you can join a workplace pension scheme through your company. Alternatively, you may prefer to set up a self-invested personal pension (SIPP).
What are the tax benefits of saving with a pension?
To encourage people to save into their pension fund, the government offers generous tax relief as an incentive. Typically, the amount you can receive depends on how much tax you pay:
- If you’re a basic-rate taxpayer, you’ll receive 20% tax relief on your contributions
- If you’re a higher-rate taxpayer, you’ll receive 40% tax relief on your contributions
- If you’re an additional-rate taxpayer, you’ll receive 45% tax relief on your contributions.
For example, if you pay the basic rate of tax and make a £100 contribution to your pension, it would only “cost” you £80 as the government would add an extra £20. This is because they would be paying tax relief of 20%.
Of course, as you’ll see later, it’s important to be aware that you have an Annual Allowance for how much you can contribute to a pension and still receive relief.
Do I have to pay Inheritance Tax on my pension if I pass away?
Another useful benefit of saving into a pension is that you may be able to use them to avoid Inheritance Tax. This is because you may be able to leave a pension pot to a loved one when you pass away, as long as you haven’t already begun to draw income from it.
Pensions are not typically considered part of your estate when you pass away, although if you’ve already accessed the wealth within, you may have to pay Inheritance Tax on it.
How much can I pay into a pension?
Theoretically, you can pay as much into a pension as you like, but you have an allowance for how much you can do so in a tax-efficient way.
You can only receive tax relief up to a threshold called your “Annual Allowance”. In the 2021/22 tax year, this stands at £40,000 or 100% of your annual earnings, whichever is lower.
While you can sometimes pay more into your pension than this amount, you will not be able to do so in a tax-efficient way as you could trigger a charge. If you’re considering doing so, you may benefit from speaking to a financial adviser to see if it’s the right decision for you.
Are there any downsides to saving into a pension?
One of the most obvious downsides of a pension is that you won’t be able to access the funds at short notice if you need them. Typically, you have to be at least 55 before you can access any pension funds you may hold, although there are some exceptions to this.
This means that while a pension can be useful for building wealth for retirement, saving money in this way may not be a good idea if you might need to access it at short notice.
Frequently asked questions
Can I have both a pension and an ISA?
Yes, you can have both a pension and an ISA. Doing this would allow you to maximise your tax-free returns and your tax relief, helping your wealth to grow more effectively.
Both ISAs and pensions can have a place in your financial planning, which is why if you’re wanting to build up your long-term wealth and retirement savings, you may benefit from using both methods.
Is it better to have a pension or savings?
Both ISAs and pensions can have their place in a proper long-term financial plan, but each has different uses.
For example, making pension contributions can help you to build a large amount of wealth to support your desired lifestyle in retirement. This can help you to retire with greater confidence.
On the other hand, one of the benefits of saving with an ISA can be that it’s easier to access your wealth when you need it. This can be useful if you encounter any unexpected financial shocks.