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Best Way to Save - Pension or ISA?

 

In recent years, opinion has differed and views have widened on how best to maximise tax efficiency on savings and this article looks to weigh up some of the factors in the debate. This is not intended as a definitive guide but rather a few key aspects to be considered when deciding how best to allocate excess capital for future use.

There are positives and negatives to both savings wrappers and it makes sense to be aware of some of these, as for some people saving into a pension instead of an ISA may be of benefit and vice versa.

ISA

Investing in an ISA offers no tax relief on contributions and as a result tax will have been paid on any earned income invested.  However, an important factor to take account is although there may be no tax relief at source on contributions on the way in, this is offset by the fact that throughout the term of the investment, ISA proceeds benefit from enjoying virtually tax-free growth and in future when accessing either lump sum or income there is, unlike pension arrangements, the ability to access the whole fund without restriction, free of tax.  For many people looking to provide an income from their capital in future this can help to avoid paying tax at the higher rate in retirement.

Pension

When saving into a pension not only is the growth within the arrangement equally tax efficient, individuals also receive tax relief on contributions at their highest marginal rate, which means a basic rate taxpayer saving £1,000 into a pension will automatically see their contribution immediately enhanced to £1,250 within the fund.  In addition, higher rate taxpayers receive a further rebate through their tax code or self-assessment tax return.  This would result in a higher rate taxpayer also receiving an enhanced amount of £1,250 directly into the fund on every £1,000 net contribution but when rebates are accounted for, a further £250 would be reimbursed.  Therefore, for a higher rate taxpayer the £1,250 now invested in the pension fund has amounted to a net cost of £750, effectively a 40% uplift from HMRC.

Although pensions are undoubtedly more tax efficient from the perspective of tax relief on contributions, it should of course be borne in mind that when eventually accessing a personal pension arrangement, only 25% of the fund is available free of tax. Withdrawals from the residual fund after the deduction of tax-free cash are liable for income tax, PAYE.  It is also worth pointing out that unlike ISAs, pension funds cannot, other than in exceptional circumstances, be accessed before age 55 and from 2028 the minimum age will increase to 57.

Conclusion

Both ISAs and Pensions have a place is forming a tax efficient retirement strategy and, dependent on the individual’s tax position it can often make sense to incorporate both to form a structured and tax efficient arrangement not only now but also in retirement.

Having guidance from an adviser can be useful in ensuring all options for savings have been reviewed.

This entry was posted on June 19, 2017