How they can work together to help you in retirement
Looking at ISAs provides an excellent example, since along with pensions they form one of the best ways to save for your long-term future.
They provide options that help you keep as much of the money as possible, rather than watch it get whittled away by high fees, inflation and the taxman.
Both are intended to offer tax-efficient ways to help you save towards your future. But we come across a lot of confusion about how each one works, and how they can be used together to facilitate a desired retirement lifestyle. Many people put their faith solely in one or the other, when the best approach for most individuals might, in fact, be to use both in various combinations.
They can both be leveraged in powerful ways, working together to achieve your goals. Broadly speaking, a pension boosts your retirement savings through attractive tax breaks, whilst an ISA allows you to grow your money without it being subject to tax.
An important caveat to this, of course, would be the Lifetime ISA (LISA), where the government contributes £1 for every £4 you commit. In 2020-21, you are allowed to contribute up to £4,000 per tax year into a LISA, and the government “top-up” represents a 25% “return” on your money. This rate of “return” is certainly hard to beat through investments elsewhere on the market and it beats the 20% tax relief on pension contributions offered to Basic Rate taxpayers.
After all, both ISAs and pensions have their respective advantages and disadvantages, and your life choices/events (e.g. when you hope to retire) might affect which strategy is best for you.
Any interest gained, dividend income or capital gains made within your ISA(s) are then free from tax. With your pension, you are entitled to put up to £40,000 per year into your pension funds (or up to 100% of your salary; whichever is lower). The government then offers tax relief on your contributions equivalent to your income tax bracket.
A Higher Rate taxpayer, therefore, would receive 40% on their contributions, allowing them to make a £1 contribution at a personal cost of only 60p.
For instance, savings in an ISA can be accessed before your retirement (except for LISA savings not used on a home purchase; stocks & shares ISAs usually involve locking your money in for a few years). A pension, however, cannot be accessed until you reach the age of 55. If you feel you need the money sooner, for whatever reason, then it will be impossible to get hold of it.
After all, it removes the temptation to withdraw money for a home improvement or other large purchase, which could result in an erosion of your income in retirement. However, this restriction could pose an obstacle if you are hoping to retire early, before the age of 55.
Any interest, income or capital gains made within your ISA(s) are tax-free, yet pension income is subject to tax once it exceeds your personal tax-free allowance (£12,500 in 2020-21).
Suppose, for instance, that you commit £20,000 into your Cash ISA each year over 20 years. By this point, you could hope to save £400,000 which is completely free from tax. If you then withdrew 5% each year to facilitate your retirement income (i.e. £20,000), then it would not face any income tax.
Suppose you put £200 a month into your workplace pension over 20 years, and the government gives you 20% tax relief on each contribution. Without the tax relief, you might hope to save about £81,000 (assuming a 5% annual return on your investments - but as always you should bear in mind that the value of investments can go down as well as up, and you may not get back what you put in). With the tax relief added on, however, you could instead save over £97,000. For Higher Rate taxpayers, of course, the 40% tax relief will add up to a lot more.
Pensions also have an edge when it comes to inheritance tax (IHT). Whilst ISA savings will be counted as part of your estate for IHT purposes, a pension is excluded. This allows you to pass your defined contribution pension down to your loved ones, tax-free (unless you die after the age of 75, at which point your beneficiaries might face a higher income tax bill).
For many people, finding a sensible combination of the two can be the best way forward. This helps you to offset some of the weaknesses of each one, whilst accessing the strengths. In the end, much depends on your own goals and circumstances. If your overriding aim is to retire in your 40s or 50s, then the balance might lean more towards your ISA savings. However, if you want to focus on minimising a future IHT bill to pass more wealth down to your family, then a pension might feature more prominently as a retirement saving tool.
To discuss which option would be best for you, get in touch with one of our advisers.
Get in touch