Pensions vs. ISAs: The best way to save

Which is the best way to save for your retirement: ISAs or pensions?

I know many of you don't trust pensions. In some ways, I don't blame you.

Perhaps, you're one of the unfortunate souls who got saddled with a woefully underperforming scheme. Or your once fantastic final salary scheme has disappeared into thin air.

Maybe you're sick of rip-off charges, government tax raids, and compulsory annuities which turn your pension into an appallingly low income that's lost forever the day you die.

But I'm going to try to convince you to trust pensions. Or at least persuade you pensions aren't always as bad as they seem. Here goes...

Pensions versus ISAs

This is a long-standing debate, but it's often concluded that the tax treatment of pensions and ISAs - although applied in different ways - comes down to the same thing (all things being equal).  

So, how does the tax treatment work?

Pension contributions attract tax relief, so you'll effectively get the tax back you have already paid on your cash. Non-taxpayers and basic rate taxpayers get 20% tax relief. This means if you pay £100 into your pension, the taxman will add an extra £25 bringing the total contribution to £125.

If you're a higher rate taxpayer, you'll qualify for 40% tax relief. Pay £100 out of your own pocket and this will turn into £166.67 with 40% tax relief.

Tax relief is a major benefit, but there's a negative side: when you take an income from your pension it won't all be free of tax. You can take up to 25% as tax-free lump sum, but the remainder is usually used to buy a standard annuity (which converts your pension pot into an income). Annuities are taxed at normal income tax rates. However, pensioners do currently have a higher personal income tax allowance than tax-payers under the age of 65.

It's a different story for ISAs. Contributions are made out of your net income. In other words, there's no tax relief. But any money you draw from your ISA is completely tax-free.

Missing piece of the jigsaw

On the surface, the tax treatment of the two looks like the same thing in reverse. This would suggest if the pension and ISA were invested in the same way and were subject to the same charges (which is entirely feasible with modern pension schemes) they would perform in exactly the same way, right?

Wrong!

There's one vital piece of the jigsaw missing: the effects of compound growth on tax relief in pensions. Or, in other words, because the pension contributions are bigger once tax relief has been added, the value can roll up more quickly over time in a pension pot, than net contributions made into an ISA.

Prove it!

Let's take look at some figures to show what effect compound growth can have on tax relief in a pension.

For the pension route, we'll make the following assumptions:

• You're a 35 year-old man.
• You pay £100 net a month until 65.
• Your total monthly contribution after tax relief is £125.
• Your pension pot grows at 7% a year with a 1% annual charge reducing net growth to 6% a year.
• The inflation rate is 2.5% a year.
• At 65, you take 25% as tax-free cash which you use to buy a purchased life annuity (more on that in a moment) with a rate of 5.8%.
• You use the remaining amount to buy a standard annuity with a rate of 6.9%.

For the ISA route, we'll make the following assumptions:

• You're a 35 year-old man.
• You pay £100 net a month until 65.
• Your ISA grows at 7% a year with a 1% annual charge reducing net growth to 6% a year.
• The inflation rate is 2.5% a year.

• At 65, you use the full ISA value to buy a purchased life annuity with a rate of 5.8%.

Purchased life annuities

Before we compare the figures, I should explain where purchased life annuities (PLA) come into it. A PLA is a way of converting a lump sum of non-pension money - say from your ISAs - into an income. It can work just like a normal annuity by guaranteeing an income for life, but PLAs are taxed in a far more favourable way.

Because you're using your own capital - and not pension money - to buy the PLA, part of the income it provides is treated as a return of capital which is free of tax. The rest is taxed at the 20% savings rate for basic rate taxpayers or 40% for higher rate taxpayers.

The amount of income you get tax-free is determined by your age when you buy the PLA and your sex. A 65-year old male will get around £832 tax-free per £1,000 of income. The remaining £168 is taxable.

I know this all sounds complicated, but just remember a PLA is far more tax-efficient than an ordinary annuity where the whole income is taxed at normal income tax rates, but it can also guarantee an income for life.

The calculations

Taking all these assumptions above into consideration, what would you actually end up with? Here are figures from pension adviser firm, Hargreaves Lansdown, which reveal different sets of results depending on your tax bracket:

Scenario one: You get basic rate tax relief on your pension and you're a basic rate taxpayer in retirement

Scenario two: You get high rate tax relief on your pension and you're a higher rate taxpayer in retirement

Scenario three: You get high rate tax relief on your pension but you're a basic rate taxpayer in retirement

In each case, the total net income from the pension beats the income generated by the ISA no matter what your tax bracket is. This is particularly true for higher rate taxpayers who become basic rate taxpayers at retirement. In this case the pension would generate £1,664 more every year than an ISA.

There's no question a pension fund will increase in value more quickly with the addition of tax relief, and will produce a greater income than an ISA used in this way.

Of course, you may decide you don't want to buy a PLA with your ISA money. You could put in an ordinary savings account, or keep it invested in an ISA, instead but there's no way of guaranteeing what level of income it might provide during your retirement.

If you need help deciding how to save for your retirement, why not ask a question on Q & A and, as you get closer to retirement, take a shot at our Prepare for your retirement goal.

Many thanks to Hargreaves Lansdown for supplying the figures

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