ISA Mortgages

Pension or ISA

In reality, the answer for most people would be both, if at all possible. However, for those trying to maximise their financial potential, it pays to understand fully the tax and long-term implications of both types of investment, so that you can make the best decisions for your personal circumstances.

Why the Question
Everyone knows that pension saving is tax free, so why are we even asking the question Consider this: when a pension investment matures, only 25 percent of the proceeds, i.e. the lump sum, is actually available, tax free. All other pension amounts are taxed at the marginal rate, which means that the tax break is only actually 5.5 percent for a basic tax payer and 10 percent for a higher rate tax payer.

For example, if a higher rate tax payer has a pension saving of £100,000 then 25 percent of the amount (£25,000) is tax free and the remaining £75,000 taxed at 40 percent. This means that the total tax payable on the £100,000 is £30,000. Consequently, the higher tax rate payer pays tax on their pension of 30 percent, a relief of 10 percent.

Therefore, it is easy to see why those who have explored the full pension calculation are considering investing in ISAs, which are truly tax free.

The Maths
Let’s look at two different investors, both with £7,000 to invest. One invests in an ISA and the other in a pension scheme. The pension investor automatically sees their £7,000 investment grossed up to a total of £11,666, assuming that the person is a higher rate tax payer. When the pots mature, let’s assume that they have both doubled in value so that the ISA is now worth £14,000 and the pension is worth £23,333.

Looking first at the pension pot, 25 percent of this can be taken tax free which amounts to £5,833; the rest is taxed at 40 percent, which means that the remaining amount of £17,500 incurs a tax liability of £7,000. The total amount, therefore, that is available is £16,333. The ISA, on the other hand, would be worth £14,000.

This strict comparison shows that the pension route appears the more cost effective. Bear in mind, however, that the balance of the pension pot (in this instance of £10,500), would have to be invested in an annuity to produce an annual income. These annuities are often at very poor rates, whereas with an ISA the entire £14,000 can be withdrawn and used as the investor chooses; there are no restrictions on what should be done with the proceeds.

Summary
Ideally, investors should use a combination of ISAs and pensions to fund retirement;
pension schemes will often produce a higher amount on termination, but there are restrictions on what the 75 percent balance can be used to purchase;
the requirement to purchase an annuity may mean that the pension scheme overall does not offer the benefits that are often perceived to be attached to such schemes;
take a look at the maths, make your own judgements and always seek professional advice if you are uncertain.