Which grows faster – Isa or pension?

The ultimate personal finance question: should you choose upfront tax relief on your savings, or tax-free withdrawals?

Billions of pounds flood into pensions and Isas every year. Both offer tax incentives but in very different ways with distinct advantages and drawbacks, so which is right for you?

When weighing up their options, savers should consider a number of factors such as tax efficiency, accessibility, flexibility, their age, their savings goal and, of course, their broader financial situation.

Money paid into your pension pot is tax exempt on the way in. Tax is due when the money is withdrawn at retirement, at your marginal income tax rate less a 25pc tax-free lump sum. Other tax charges can apply, if you break the annual limit on contributions, for instance, or if you tried to make a withdrawal before the age of 55.

Contributions to Isas, on the other hand, are made with post-tax income, after which they are tax free until your death.

Romi Savova, of pension firm Pensionbee, said that the relative tax boost that you can get from the Government was much higher in pensions.

A basic-rate taxpayer who wanted to put £100 into their pension would only have to pay £80, as the Government tops up the contribution at the saver’s marginal income tax rate – in this case 20pc. Higher-rate taxpayers, those earning £50,000 or more a year, would pay in £60, with additional-rate earners paying £55 to end up with the same £100 in their pension.

Mrs Savova said: “With pensions you get a lucrative top-up to your savings that you don’t get with Isas.”

The exception to this is the Lifetime Isa, which allows savers to put away up to £4,000 each year until they reach the age of 50. Savings enjoy a 25pc bonus, up to a maximum of £1,000 per year.

In contrast, pensions can benefit from tax relief to a much higher limit. Savers can funnel up to £40,000 into pensions each year while getting tax relief at their marginal rate – which for many people will be higher than the Lifetime Isa’s 25pc (which is equivalent to basic-rate relief on a pension).

Using “carry forward” rules, you can save even more than £40,000. Unused allowances from the previous three tax years can be added. Conventional Isas have a £20,000 annual allowance.

Over time, the difference between the boost given to pensions and Isas becomes clear. A basic-rate payer investing £3,000 would be £1,137 better off after a decade by putting it in a pension rather than a stocks and shares Isa. Assuming 5pc investment returns, the pension pot would have grown to £5,686 after 10 years – helped by a £750 top up at the start – while the Isa would be worth £4,549. Even after tax, assuming the saver is still a basic-rate payer, the pension is worth £4,833.

Both pensions and Isas allow investments to grow free of dividends, capital gains and income tax. Isas’ appeal is that withdrawals are also entirely tax free.

With this in mind, Maike Currie, of Fidelity International, a fund group, said people should have both an Isa and a pension.

“Ultimately, it’s a good idea to bring your Isa and pension planning together,” she said.

“In recent years, the tapering of the annual allowance for those earning more than £150,000 means pensions have become less of an option for high earners, many of whom can only contribute £10,000 a year.”

Wealthy savers affected by the taper have increasingly turned to Isas, which have a maximum contribution limit of £20,000 a year, as a way of sheltering money for their old age. Isas can also be a tax-efficient alternative for high earners who have maxed out the £1.055m lifetime allowance in their pension.

“It’s important to marry savings vehicles like an Isa with your pension, perhaps funnelling some of these savings into your pension as you near retirement,” she said.

Beyond the tax uplift, pensions have become a vehicle for transferring wealth between generations.

While Isas allow savings to roll up tax free, there is one levy to which they are not immune. On death they are liable to inheritance tax as they form part of the deceased’s estate – whereas pensions are not. This has allowed savers to shield large sums from the taxman by filling up pension accounts.

Pensions may appear more attractive on the tax front but when it comes to flexibility and accessibility, Isas come out on top.

Pensions are locked away until the age of 55. Isa money can, generally, be accessed whenever you like.

Laura Suter, of broker A J Bell, said Isas can also be an ideal option for savers over 75 who have left it too late to open a pension, as Isas have no age limit, she added.

The relative inaccessibility of pensions can also help build up large sums, as money is kept out of temptation’s way.

“The fact that you have to leave your money invested over decades also comes with its own rewards, as you will benefit from the snowball effect of compound interest,” Mrs Currie explained.