At a glance:
- While their tax-efficiency makes pensions essential to any retirement savings plan, they’re just part of a bigger toolkit available to savers and investors.
- The contrasting tax treatment of pensions and ISAs means they can work best when used alongside each other.
- Working with an adviser can help you maximise the benefits of the two products and ensure they fit with your long-term plans.
It’s no secret that when it comes to saving for retirement, pensions remain the first port of call. There are very good reasons for that, not least their tax benefits. But while pensions should form a fundamental pillar of any retirement savings plan, the days of them being the only pillar are long gone.
These days, saving for retirement is all about choice and flexibility. No longer is it about relying solely on a pension in retirement. With people working today expected to live for two or three decades in retirement, and more income options available on reaching that stage, it’s important to make the best of the different tools at your disposal.
So, while pensions remain the cornerstone of any decent retirement plan, they can work well alongside other options.
The most obvious is an Individual Savings Account (ISA). Introduced in 1999 to replace Personal Equity Plans (PEPs), ISAs are now a big part of the retirement savings landscape.
“Now that it’s easier to access a pension as well as an ISA, the two products are much more broadly aligned,” says Liam White, Associate Director at Capstone Financial. There’s long been a debate as to whether ISAs or pensions are the best retirement savings option.
In reality, however, using both a pension and an ISA is perhaps the best approach of all, not least because that gives you instant diversification and more options. “Having both offers more choices when making retirement decisions, and with the tax advantages you’re getting the best of both worlds,” says Liam.
Complementing and dovetailing
The main difference between ISAs and pensions is their tax treatment. The annual ISA allowance is currently £20,000, which can be used across Cash ISAs, Stocks & Shares ISAs, Innovative Finance ISAs, Lifetime ISAs and Junior ISAs (albeit with annual limits of £4,000 and £9,000 on the latter two respectively).
It’s Stocks & Shares ISAs that we’re usually referring to in the context of retirement saving, although Cash ISAs are also an important part of the toolkit. While the money you pay into an ISA will generally be taxed beforehand, as it’s paid out of net income, there’s no Income Tax due on the interest or dividends you receive.
In contrast, with pensions there’s no tax when you pay in. This is because the government gives you tax relief on pension contributions at your marginal Income Tax rate.
This means that for every £80 paid in, your pension scheme can claim another £20 in tax relief (so that a £100 contribution costs just £80). Higher-rate taxpayers get 40% pension tax relief, so they have to pay in only £60 for every £100 contribution, while those on the 45% Income Tax rate can claim relief at 45%. Anything over the basic rate of tax must be reclaimed via the individual’s tax return and are subject to eligibility. However, Income Tax is charged on pension withdrawals above the 25% tax-free cash entitlement.
The other big difference is that you can’t usually access your pension until you turn 55 (rising to 57 in 2028), whereas there’s no such age restriction on withdrawing money from an ISA. “Pensions tax relief provides tax-efficient growth and access to a proportion of tax-free cash, while your ISA gives you another allowance entirely, so it makes sense to use both,” says Liam.
Mixing and matching
Using both also helps savers navigate the annual and lifetime pension allowances. The former is the amount you can contribute in a tax year while still benefiting from tax relief (currently £40,000, but reducing by £1 for every £2 of adjusted income you earn over £240,000).
The lifetime allowance is the maximum amount of pension savings you can build up over your lifetime without facing a potential tax charge, and is currently frozen at £1,073,100.
The way to approach it from a tax perspective is to consider where the two products fit into your overall financial plans. This is where a financial adviser can add particular value, while also helping you answer questions such as which pot to access first in retirement and what the tax implications might be.
“When it comes to all the allowances and limits, the adviser will have a watching brief over those and guide you along the best course of action,” says Liam. “For example, your plan might be to access the ISA before age 55, especially if you want to retire before then. It depends on your future plans, and that’s where an adviser can help you map out which products to use.”
They can also ensure you’re investing in a way that’s best suited to achieving the goals you’re aiming for.
“If people aren’t sure which to use, that tells us they’re lacking a plan,” says Liam. “We will sit down with you and work out what you want to achieve and the purpose of the savings you’re putting aside.”
A Stocks and Shares ISA does not have the security of capital associated with a Cash ISA.
The value of an investment with St. James’s Place will be directly linked to the performance of the funds selected and may fall as well as rise. You may get back less than the amount invested.
The levels and bases of taxation and reliefs from taxation can change at any time and are dependent on individual circumstances.
Please note that St. James’s Place do not offer Cash, Innovative or Lifetime ISAs.