Pensions vs Isa: where to save for max gains

Both allow savers to shelter their money from the taxman, but which is the better place to stash your cash? Sam Benstead reports

Pensions and Isas are the two most powerful tax-free accounts available, but they offer different perks for your pounds. Isas contributions must be made out of a person’s post-tax income and are capped at £20,000 a year. However, there is no limit to how large the Isa can grow and the pot can be accessed at any time. Once money is inside the wrapper, it is free of income, dividends and capital gains taxes, although Isas do incur inheritance tax when they are passed on after death.

Contributions into pensions, meanwhile, attract tax relief at the saver’s marginal income tax rate – so the initial contribution is topped up by the Government – and are capped at a comparatively more generous £40,000 a year for most people. Once a person earns over £240,000, this annual limit starts to taper to £4,000.

However, pensions cannot be accessed until the saver’s 55th birthday – rising to 57 from April 2028 – and only 25pc can be withdrawn tax free, with the rest charged income tax rates. There is also the “lifetime allowance”, where savings above the £1,073,100 limit are taxed at up to 55pc.

So which does more for your savings? A person with £10,000 to invest – and no immediate need for the money – would be better off putting this in a pension. A higher-rate taxpayer would end up with an initial pension contribution of £16,666.67, thanks to tax relief at 40pc. Assuming annual returns of 6pc, this would grow to £29,847 after 10 years and £53,452 after 20 years.

The Isa saver, however, who did not receive the Government top-up, would end up with £17,908 after a decade and £32,071 after 20 years.

Liz Alley of Brewin Dolphin, a wealth manager, said pensions were the best option for money that could be locked up for a long time.

“Pensions give their main tax break upfront, with income tax relief added to your personal contribution when you pay into your fund. For example, a basic-rate taxpayer only needs to pay in £80 to make a £100 contribution, once the 20pc tax relief has been added. A higher-rate taxpayer who receives tax relief at 40pc would only need to pay in £60,” she said.

“This is a very generous tax boost and means you are essentially given free money to invest and grow in the stock market, and this can mean a larger fund compared to an Isa, all other things being equal.”

People who need to access their savings before their mid-50s, however, should save into an Isa.

Ms Alley said: “For pre-retirement goals, such as buying a house, carrying out a home renovation or paying for school fees, Isas are the best option.”

She added that pensions and Isas could be used successfully together to achieve the best of both worlds.

“If you’re not sure what your goals are, splitting your savings between Isas and pensions is a great option. Your money will have the opportunity to grow tax-efficiently, and you’ll be saving for your retirement in addition to your short-term goals. If you’ve already maxed out your Isa allowance, it might make sense to focus on pension saving instead,” she said.

Jon Greer of Quilter, a financial planner, said pensions had the extra benefit of being outside someone’s estate, so they can be passed on without incurring inheritance tax, which is levied at 40pc on assets over £325,000.

“Money held in an Isa forms part of the estate on the death of the holder. If this is passed on to a spouse, it will be Iht-free, but if it is inherited by anyone else then it could trigger a payment to the taxman,” Mr Greer said.

Pensions sit outside your estate for tax purposes, but inherited pensions are still liable for income tax when the money is withdrawn, unless the saver dies before their 75th birthday.

Although Isa contributions do not attract tax relief, there is one account that earns a Government top-up: the Lifetime Isa. Savers can put in up to £4,000 each year until they are 50, so long as they make their first contribution before 40. The Government adds a 25pc bonus, up to a maximum of £1,000 per year. Given that the American stock market has historically returned about 8pc a year, getting an instant 25pc return is attractive to many savers.