More people are starting to come to the realisation that we'll need to provide for our own retirement if we want a comfortable lifestyle after we leave the workplace. Although rules around when and how we can take our pensions are more flexible now, the complexity of the pensions market can make it difficult to know what to do.
With auto-enrolment now well-established, many people will be enjoying the benefits of workplace pension schemes. These include contributions from your employer as well as tax relief – there is no better way to save for retirement than this, as you are in effect getting 'free' money. But what about when it comes to a private pension or an ISA; which should you put your money into? Here are a few things to consider.
One of the main advantages of a pension over an ISA is tax – your pension provider can claim tax back on your contributions. So, for every £100 you contribute, you're actually contributing £125 into your pension if you're a basic rate taxpayer. If you pay tax at a higher rate, you can claim the difference through your tax return.
When you retire, your pension payments are subject to income tax in the same way as your employment income. However, you are likely to be drawing a smaller income, and you may fall below the threshold anyway and will therefore pay no tax.
ISAs are tax-efficient in terms of having your interest or capital gains paid tax-free, but because you'll be paying in money you have earned, you'll have already paid income tax on that amount. Nevertheless, you could use your ISA – especially a Lifetime ISA – to provide an income when you retire, and this will be tax-free.
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Depending on the funds in which your pension pot is invested, there is an investment risk with a pension, and your pot has the capacity to fall as well as rise in value. You can normally choose lower-risk funds according to your attitude towards risk, but even with these there is the possibility, albeit a lower one, that the fund you are invested in falls in value.
If you put your money into a cash ISA it will carry no investment risk at all, though it would be at risk from the eroding effects of inflation. Even if the bank or building society were to go bust, you would be protected for up to £85,000 per institution under the Financial Services Compensation Scheme. For people seeking a better return from their cash ISA, a stocks & shares or Lifetime ISA may be a consideration, but as with pensions, these involve more investment risk. Investments also come with a lower compensation limit, which currently stands at £50,000 for investment ISAs.
You can't currently access your pension pot until the age of 55, which will be pushed back at the same pace as the State Retirement Age, moving to age 57 in 2028. Conversely, when investing in an ISA you can access your money whenever you want (except in the case of a Lifetime ISA), although there may be a penalty for doing so if you've invested in a fixed rate product. However, this freedom could be a downside to saving for retirement if you don't have good willpower; you should think very carefully about touching the money you have set aside.
Anyone over the age of 55 can take a lump sum of up to 25% of their pension pot tax-free. Most people would do this at the point they choose to retire. Additionally, since April 2015 pensioners have the option to access their entire pension pot, with anything above the tax-free element taxed as earned income at the relevant income tax rate.
One main option available to pensioners with a pot is income drawdown, whereby they can take an income directly from their pension pot. Alternatively, many people may choose to purchase an annuity with their pension – a guaranteed income for life. It can seem a big decision to make, but if you research the market properly, then an annuity can offer an unrivalled level of security.
If you have ISA savings, then you can decide either to take an income from the interest or investment returns on your ISA pot, or to take a portion of the actual pot itself. However, you must remember that when you start to eat into the capital in your ISA, the interest you earn will become less.
If you are 55 or over and own your own home, you could consider using equity release to significantly boost your retirement income. You can normally release up to 40% of the value of your home and continue to live there, usually without having to make any repayments.
If you’ve purchased an annuity, then you will have a guaranteed income for life, but if you’ve decided to drawdown your income by taking income in excess of investment growth in the fund, there is a chance it could run out before you die or at the very least greatly reduce your income in later life.
When it comes to an ISA, if you are only using the interest or returns from your account, then (depending on investment performance if you choose to leave your pot invested) your income should not run out in your lifetime. If you decide to take a portion of your ISA pot each month or year as an income, it's possible that you could use this up in the same way as in pension drawdown.
When looking at the pension and ISA debate there is no clear-cut answer. Your decision depends on many considerations, including your attitude to risk, your own level of willpower and what you want out of your retirement. With the pension freedoms, there is even less difference between the two, with tax relief on the pension and the minimum age at which it can be accessed being the main differences.
Another advantage to a pension scheme would be if you were ever made redundant or became unemployed for any reason. Your pension pot does not affect your entitlement to state benefits, whereas an ISA counts towards savings, which can affect your entitlement to certain means-tested benefits.
Pensions will always win when it comes to tax efficiency – and a company scheme is a no-brainer – but if it is flexibility as to when you can access your money that is important to you, then the ISA comes into its own.
Perhaps it all comes down to the old saying of having your eggs in more than one basket; if you make the most of both products, you can have the best of both worlds and increase your options when you retire.
Disclaimer: This information is intended solely to provide guidance and is not financial advice. Moneyfacts will not be liable for any loss arising from your use or reliance on this information. If you are in any doubt, Moneyfacts recommends you obtain independent financial advice.