Pension or ISA? Maybe you don't have to choose

With all that’s been going on in the world over the last 12 months or so, the likes of savings, investments and pensions are probably not something you’ve given much thought to.

But in reality the world keeps on turning and the need to review your finances doesn’t disappear. With the end of the 2020/21 tax year creeping up on us, this could be a great opportunity to review your finances, and make some important changes – especially when it comes to being more tax efficient.

Tax is a necessary part of life, but paying more than you need to on your savings and investments could hold you back from accomplishing your financial goals. That’s why it can really pay off to factor tax into your long-term plans. Both an ISA and a pension could play valuable roles in your overall financial planning. Often they’re pitted against each other to see which one is best, but you might not have to choose between one or the other.

Why a pension can help

The introduction of the pension freedoms in 2015 opened up new options and brought about new flexibility when it comes to money purchase pensions.

Most people are unlikely to come close to exceeding the lifetime allowance, meaning they could pay more into a pension – and benefit from tax relief – to support their financial future.

Gareth Smith, Skipton Retirement Planning Lead

Previously, you were often restricted to using at least three-quarters of a defined contribution pension to arrange an income in retirement. Now, the pension freedoms mean you have new options to take your pension as a lump sum (subject to tax), or even retain the fund to provide benefits on your death.

Gareth Smith, Skipton’s Retirement Planning Lead explains, “When you invest into a pension, you benefit from tax relief of at least 20%. Effectively, for every £80 you pay in, tax relief means a further £20 goes into your pension pot. If you’re a higher or additional rate taxpayer and you claim for it through self-assessment, you can get tax relief of 40% or 45% respectively.

“Typically, you can pay in a maximum of £40,000 each tax year, and the lifetime allowance limits you to having £1,073,100 (increasing to £1,078,900 for the 2021-22 tax year) in your pension before it is subject to additional tax. Most people are unlikely to come close to exceeding the lifetime allowance, meaning they could pay more into a pension – and benefit from tax relief – to support their financial future.”

There are still important tax considerations around using your pension. You can’t access it before 55, and only 25% is tax-free to take. The rest is taxed at your marginal rate, making it important not to withdraw too much in one go.

You should also appreciate that a pension is a long-term investment and your capital is at risk. You could get back less than you paid in. Your eventual income will depend on the size of your fund at retirement, interest rates and tax legislation.

Whether it’s understanding your pension options or investing your ISA allowance, we can help. You can arrange a call back with us to talk through your options.

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How do pensions compare to ISAs?

Mature man looking at view

With ISAs, there is no tax relief when you invest your money, but once inside an ISA, you don’t have to pay any tax on the growth you achieve, or to make withdrawals. For the 2020/21 tax year, you can invest up to £20,000 in an ISA.

The ISA allowance doesn’t roll over, so if you haven’t used this tax year’s allowance it could prove really beneficial to do so.

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There’s no doubt that ISAs remain a valuable option and certainly shouldn’t be ignored. “Savvy investors are likely to make good use of both pensions and ISAs,” reveals Gareth. “It’s all about considering your long-term goals, and how and when you need your savings.” The tax treatment of your investments depends on your individual circumstances and may be subject to change in the future.

Another type of ISA is the Lifetime ISA (LISA). It has two purposes – to save for a first home or to save for retirement. You can only open one if you’re aged between 18 and 39 and you can save up to £4,000 per year. You also receive a 25% bonus from the government, up to a maximum of £1,000 a year, as long as you use the money within certain restrictions (otherwise you pay the government a penalty). Visit our LISA page for more details.

Building a stronger legacy

There’s also another valuable tax benefit from pensions – the way your loved ones can inherit them. If your estate is worth more than your personal threshold, your family might have to pay inheritance tax on everything above it. Your estate includes property, car, savings and investments – but doesn’t usually include pensions.

This is not a new development, but the 2015 pension freedoms included rule changes around inheriting pensions, which is where there is a potential opportunity.

Gareth explains, “Before the 2015 pension freedoms, if you died over the age of 75, or after taking money from your plan, your remaining pot could only be passed to loved ones after incurring a 55% tax charge. This has been scrapped. If you die before you’re 75, your family can inherit your pension fund tax-free. If you die after 75, they will only have to pay tax at their marginal tax rate, rather than 55%, to receive these funds.”

young couple sat at kitchen table eating breakfast

The fact it isn’t part of your estate means you can, in theory, have up to £1,073,100 in a pension (for the 2020/21 tax year), and it can be passed on to your family without incurring inheritance tax. There may still be tax to pay, if you were to die after your 75th birthday but your beneficiaries might choose to receive the benefit at a time when they themselves are paying a lower rate of income tax - e.g when they retire.

The importance of financial planning

Gareth concludes, “There are some really valuable opportunities to be more tax-efficient with your savings, pensions and investments – and it could make a major difference to you and your family’s financial future. As you would expect, investing your money comes with risk. The value of the funds can go down as well as up, and you may get back less than you invest.

You also need to bear in mind that if you take too much income too quickly from your pension fund then your fund could be depleted or run out altogether.

There’s no pressure to act on Skipton’s advice – or an upfront fee to pay to hear them. You’ll only need to pay for the advice if you act on a recommendation. And even then, Skipton will make it clear what you’ll pay before you make a decision.”

Important information

Our recommendations are likely to include stock market-based investments. These are not like bank and building society savings accounts as your capital is at risk and you may get back less than you invested. The value of your investments and any income from them may fall as well as rise.

Get in touch

For more information on our service and to find out whether you could benefit from financial advice, call our specialist team today for a free initial consultation.