Pensions vs ISAs: what's best for savers now?

The rules that govern pensions and individual savings accounts (ISAs) have undergone a radical shift but which one should you choose in the new world of savings?

When looking at the merits of ISAs and pensions, savers must consider tax, accessibility and contributions to decide which wrapper suits their financial needs best.

Tax

ISAs are a very popular way to save as any returns or interest made on money invested through them is tax-free and money can be withdrawn tax-free.

The big difference with pensions is while ISAs are tax-free on money out, pensions offer the tax break on the way in.

Pension contributions receive tax relief, which is essentially free money from the government. For every contributions made, the government will give another 20%, 40% or 45% on top depending on the top rate of income tax paid.

This means a basic rate taxpayer paying £80 into a pension will receive another £20 on top, making the contribution worth £100. Gains and income received on pensions investments is also rolled up tax-free.

Pensions are hit with tax on the way out apart from the allowable 25% tax-free lump sum. When an income is taken from a pension on retirement, either through 'drawdown' or buying an annuity that income is taxed, just as income is taxed in working life.

Adrian Walker, a retirement expert at Old Mutual, said most pensioners pay 20% income tax, so the tax relief is even more beneficial to those paying higher rate tax now. Those people receive 40% tax relief but pay 20% income tax in retirement.

"It is highly unlikely you will be a 40% taxpayer in retirement, so you get 25% out [of you pension] tax free and pay 20% on rest," he said.

However he said those wanting to take lump sums out of their savings may be better offer using ISAs because there will be no tax to pay but someone taking a large amount out of a pension could push themselves into the 40% income tax bracket.

Paying in

The ISA allowance was increased considerably in the last Budget, from £11,520 to £15,000 a year. Aside from the surprise rise in the allowance, the chancellor changed how the money can be changed inside the ISA. Previously, the full allowance could be saved into a stocks and shares ISA or half the amount could be saved in a cash ISA.

However, the whole £15,000 can be saved in a cash ISA now or split between a stocks and shares ISA in any way the saver wishes. Additionally, savers can now transfer from stocks and shares back into cash whereas previously the transfer could only be done from cash to stocks and shares.

Pensions have a larger allowance, with investors able to save a total of £40,000 a year or £1.25 million over a lifetime.

Not only is the pension allowance much larger than the ISA allowance, thanks to auto-enrolment all employers will have to pay into a pension so workers receive an extra savings boost.

Accessibility

ISAs are a popular way to save because the money is easily accessible; money put in can be taken out at any time, although doing so means it cannot be paid back in above the £15,000 annual limit.

When the money is withdrawn it can be taken out as income or as a lump sum, however the individual wants to take it.

Pensions on the other hand are inaccessible until age 55 and that age is due to increase to 57. Despite having to wait for the cash, the new pension freedoms mean that when a saver does they have a lot more options.

Now pensioners can take their pension savings as a cash lump sum, less of any income tax due, or they can put it in 'drawdown' where it remains invested and they take an income from it. Alternatively, they can go via the more traditional route and buy an annuity.

"People need to think about financial planning; are you putting your money away from the long term, or will you want access before age 57," said Walker. "If you want access then I would use an ISA because young people will be locked out [of their pension savings] until at least 57 and maybe even longer."

On death

The tax treatment on death for both ISAs and pensions has been changed recently. ISAs can now be passed to a spouse while being kept out of the inheritance tax (IHT) net which is a bonus.

However, pensions have been made even more attractive from an IHT point of view. The government has abolished the 55% death tax on pensions if a saver dies before 75 and reduced it to 45% if a person dies after age 75 and the money is taken as a lump sum – this figure will reduce to the beneficiary's rate of income tax in 2016.

For beneficiaries who take the pension as an income, it will be taxed at their income rate.

In further good news, the pension can be left to anyone a person likes, not just a spouse or a child aged under 23.

"If you are putting money away then part of it does need to be put away for the long term but think also about the way money can be taken out...ISAs are best for accessibility but pension pensions work on tax breaks," said Walker.

Read more:
New pension rules: how to avoid a huge tax bill

Pension changes 2015: 45% tax sting for those who cash in pension

Budget 2014: a cap on ISAs would be the final insult to savers