Nobody wants to work full time forever. However, the only way you can ensure that you can relax once you retire is if you have enough money saved somewhere. When it comes to retirement, most people opt to put their money in pension funds or opt for individual savings accounts (ISA)1. These two options have similarities and differences, and choosing which is right for you depends on a couple of factors.
Pensions are explicitly designed to help you save for retirement. You make contributions or payments to your pension scheme and then on attaining the retirement age, (set by your provider or the state), you can access the money.
On the other hand, individual savings accounts are products that allow you to deposit your money without paying additional taxes on the interest it attracts. These financial products are provided by financial institutions, building societies and other providers. With these plans, you can save up to £20,000 every year tax-free. There are various forms of ISAs, and they include:
- Cash ISAs
- Help-to-Buy ISAs2
- Lifetime ISAs
- Stocks and Shares ISAs
- Innovative Finance ISAs
- Junior ISAs
With this in mind, how do you navigate through the two options, and should you pay into a pension or an ISA? Which option works best for you and which one will help you have a comfortable retirement?
Well, lucky for you, here’s a comprehensive guide to help you out.
Do you want a product where you can put in money without caps on the contribution, or are you looking or one where you can make frequent withdrawals?
With a pension3, you can deposit only up to a certain amount of money per year. There’s also a cap of 1.05 million quid on pensions. Having more than this will attract a fine. Additionally, you can’t withdraw from that pension until you attain the agreed-upon retirement age.
Individual savings accounts are a bit more flexible here. You can make deposits and withdrawals at any time, and the limit on the amount of money you can deposit is on an annual basis. It means that there’s no limit on the total amount you can accumulate over time.
Both the pension and ISA come with attractive incentives to save your money without paying it all to the taxman. If you opt to set money aside in a pension fund, you get tax relief, and the government will 25% back. Simply put, if you put in 100 quid, the government top you up with 25 quid. The percentage can even be as high as 31% for higher taxpayers. However, with pensions, when you finally collect your money, you will need to fork over some income tax.
With ISA’s, the amount of money that will go to your account will have already been taxed. The interest acquired, on the other hand, won’t attract any taxes. Therefore, the amount of money you see in the account is what you can access. However, unlike pensions, the government won’t add to your money.
The money paid into both the ISA and pensions are invested in various ways. With an ISA, you find that you can invest in stocks, shares4, real estate, and even peer to peer lending. The option here is limitless. With pensions, however, things are a bit more rigid. Unless you opt for a self-invested personal pension, your investment options are limited to what your pension provider offers.
The Inheritance Angle
There’s always the question of what happens to the money you had set aside if you die. With pensions, you need to keep in mind that money in your pension scheme is held outside your estate. If you pass on before you’re 75, the money goes to your next of kin or estate, without them having to pay the income tax. However, if you were above the age of 75, they’ll need to pay the 40% inheritance tax5. ISA’s are considered part of your estate. It means that on your death, they’ll go to the listed next of kin, tax-free.
From the above analysis, it’s easy to see that both ISA’s and pensions come with various pros and cons. ideally, the ideal product will depend on your needs and a financial expert can help you identify which will work better for you. However, nothing stops you from reaping the benefits of both products by setting up a pension and an ISA, to which you can be making contributions.
The decision to put your money in an ISA or a pension wholly depends on your needs. If you want the fund to grow systematically, without you touching it, then a pension plan might be ideal.
Alternatively, if you prefer having access to the money and control over the investments, then an ISA might be a better option. Both products will allow you tax breaks in different ways. Pension schemes offer you at least 25% in tax refunds, while with an ISA, the interest your money attracts is tax-free.
No, it isn’t. With an ISA, the money deposited in the account post income tax can attract interest tax-free. With pensions, you get a government tax refund equal to the income tax you were charged in your account.
However, you’ll be charged income tax when getting your payments. Additionally, you can only access your pension on attaining the retirement age. The restriction, nonetheless, doesn’t apply to an ISA.
No, you can’t. The regulations don’t allow for the transfer of funds for a pension scheme into an ISA. However, if you have more than one pension, you can consolidate them into one. On reaching the determined retirement age, you can withdraw the funds and invest them in an ISA.
You might also want to keep in mind though that making large withdrawals from your pension makes you liable to pay significant taxes.
Yes. Essentially, your pension is like long term savings, with the additional benefit of tax relief. You set up a pension fund to allow you to set aside money, bit by bit, for your retirement.
The government’s tax relief also ensures that the tax you pay on that contribution is refunded into your account.