Five reasons why ISAs are better than pensions

Here are five key reasons why ISAs could be a better way to save for your retirement than a traditional pension scheme.

I know many of you hate pensions, and I can understand why. It’s a nasty combination of past mis-selling, tax raids by the government, collapsing final salary schemes, poor performance, high charges, low annuity rates….and so the list goes on.

I don’t deny there’s truth in all of these. But I think most of us would all agree wholeheartedly on one thing: We must be responsible for our own retirement provision.

It’s a very serious mistake to rely on the State. But if you turn your back on the traditional pension route, how should you prepare for your financial future?

Think twice about ISAs

ISAs are fast becoming a popular alternative to pensions. On the surface, ISAs and pensions don’t appear all that dissimilar. After all, both enjoy tax breaks and can be invested in much the same way. But there are five clear reasons why ISAs could have the edge:

1. Access to your cash

Many of you don’t like the idea of your savings being locked away until you reach your fifties, sixties and sometimes beyond. But that’s exactly what happens with a pension scheme where you won’t normally be able to get your hands on any cash until you retire - and certainly not before you reach 55.

But with an ISA you have access to your money whenever you need it. Of course, I’m not suggesting you raid your savings carelessly, but it’s good to know there are funds available in an emergency.

That said, don’t forget, you have a limited ISA allowance every tax year - which is currently a total of £10,200 of which £5,100 can be put in a cash ISA if you wish. Once you have used it all, if you then make a withdrawal, you won’t be able to replace that money until you have a new allowance available in the following tax year. For a round up of some of the best ISAs around at the moment, have a read of Top new ISAs for savvy savers.

2. More flexibility

The opportunity to draw on your ISA savings whenever you like gives you the freedom to vary the amount and frequency of income. It’s much more difficult to adapt income taken from a pension.

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Once you retire, your expenditure is unlikely to be evenly spread throughout the year, so you can alter your withdrawals to suit your own personal spending pattern.

This will also allow you to leave the remaining fund invested with the potential to earn more capital growth if you're preared to continue taking a risk. Although, you may want to think about switching your money out of shares once you're retired, to protect the value from a sudden drop in the stock market just as you need to draw on it.

Again, any money you take out will be completely tax-free as there’s no capital gains tax (CGT) or income tax to pay.

3. No annuity required

I think for a lot of you this is the real biggie. Most pension savers will only be able to take an income from their pension by converting it into an annuity. But the trouble is annuity rates are relatively low right now, representing pretty poor value for money. On top of that, once you're locked into an annuity, you’ll be stuck with it for the rest of your life.

But with ISAs there’s no need to buy an annuity when you want to take an income. As I mentioned above, you can draw money from your ISA whenever you like.

4. Retain your capital

Another common objection to pensions is that capital is normally lost on death*. Imagine you have a pension pot of £50,000 which pays out an income of £3,500 a year but you only survive for two years. This means, you will have received a total of £7,000 in income from your pension fund, but the remaining £43,000 will be lost. That’s a huge risk to take.

But with ISAs, the rest of your fund remains intact, which leads on to number 5.

5. Your family

Any remaining ISA money can be passed onto your dependants on death. There’s no risk of losing the lion’s share of your capital as there is with pensions. But don’t forget, ISAs lose their tax-free status when they are passed on to the next generation. But that’s a whole lot better than losing the fund entirely.

And now for the disadvantages

Of course, ISAs aren’t perfect. Don’t ignore these drawbacks:

Lower level of contributions

At the moment you can invest a maximum of £10,200 into an ISA per tax year. Although that equates to £850 a month, it may not be sufficient for high earners.

Loss of tax-free cash at retirement

When you retire you'll be able to take up to 25% of a pension fund as a tax-free cash lump sum. But this isn't an option with ISAs, which means from a tax perspective, pensions are more generous.

Loss of employer contributions

I think this is the greatest drawback of all. Some employers are willing to pay into their employees' pensions as an extra perk of the job. This can be a huge boost to the value of the pension fund. But there's no such thing as employer contributions into ISAs.

If your employer is prepared to give you what is essentially free money, I think you'll probably be better off choosing a pension instead.

*Income from an annuity can be guaranteed for five or ten years regardless of how long you survive. If you die within that period your beneficiary will continue to receive your income. Once that time has passed income will stop.

This is a lovemoney.com classic article, updated for 2011.