Pension vs ISA: Which Should You Invest In? - The Humble Penny (2024)

Pension vs ISA: Which Should You Invest Money In? – Ad | This is a paid partnership with PensionBee

The question of whether to invest in a pension vs ISA is one that we receive a lot, particularly from those in their 20s and 30s.

This is usually because people in this group are at the stage in their lives where they are considering how to start investing money.

Apart from the current age of an investor, there are other considerations for whether to invest in a pension or ISA.

Such considerations include the type of work that you do.

For example, are you self-employed or are you employed (basic vs higher rate taxpayer) or are you an entrepreneur?

The intentions that you have for your future career and life also matters.

For example, if you plan to go from being an employee to becoming an entrepreneur, the choice of whether you invest in a pension vs ISA would be different.

Or if you plan to retire earlier, for example, the choice of a pension vs ISA would matter especially if you are planning to retire before the age of 55

Given that investment is all about risk vs reward we’ll consider this aspect as we analyse whether it is more worthwhile to invest through a pension vs ISA.

One thing that gave me a lot of clarity in considering my pension vs ISA was the need to have previous employer pensions consolidated into one pot.

This just meant that I was able to see my total pension amount in one place and compare it to my ISA pot.

By doing that I was able to figure out what balance of contributions across my pension vs ISA was suitable in helping me achieve my financial goals.

The one company that makes this process of consolidation very easy is PensionBee.

I wish I knew about them years ago when I painfully tried to get my finances in shape and combine my various pension pots.

PENSION vs ISA: The Big Debate

Let us now consider the pros and cons of investing in a pension vs ISA by looking at the individual benefits of each one:

ACCESS TO MONEY

Pension

In the UK, you cannot access your pension until the age of 55.

This is a particular challenge for me personally in my 30s because I have absolutely no idea what things might look like in 20 years' time.

This age limit of 55 can change at any point in the future depending on what the prevailing government decides.

Assuming that the age of 55 remains the same, you have the option of withdrawing 25% of your pension tax-free.

The rest of the money can be left invested in the stock market or withdrawn but with tax paid at your marginal tax rate at the time.

ISA

The beauty of the ISA is that it gives you complete access to your money whenever you want it.

This is especially useful for anyone who wants to live a particular lifestyle earlier in their lives rather than later on.

The type of ISA that you have does play a role in your ability to access your money.

For example, a Junior ISA cannot be accessed by your child until they are 18 years old.

However, a regular Stocks and Shares ISA or a Cash ISA can be accessed at any point.

Note that once you take cash out of your ISA you cannot put it back in the same tax year.

So make sure that you keep an eye on the tax rules when you withdraw your money from an ISA.

TAX RELIEF

Pension

When you pay money into an employer pension or a Self-Invested Pension Plan (SIPP), you get tax relief because the government gives you back the tax that you paid on your income.

The amount of tax relief depending on whether you are a basic rate or higher rate or additional rate taxpayer.

A basic rate taxpayer gets a 25% tax top-up for contributions into their pension.

I.e. for every £80 that you put into your pension you'll get an additional £20 top-up.

This is extended for higher rate taxpayers by another 25%.

I.e. for every £80 that you put in you get a top-up of £20 and can claim another £20 via your Self-assessment tax returns. A total of £40 for every £80 i.e. 50%.

Additional rate taxpayers get an additional 31% on top of the initial 25%.

These rebates play a critical role in your decision about whether to invest in a pension vs ISA.

A basic rate taxpayer is more likely to benefit from investing in their ISA compared to a pension.

This is because they are only getting back a 25% rebate and will in the future only get a 25% tax-free lump sum available.

Whereas a higher rate taxpayer will get back 50% of amounts contributed to their pension compared to the 25% tax-free lump sum when they withdraw.

So the higher rate taxpayer stands to gain a lot more on balance because they will have a lot more of their money in a tax-free environment working for them for years before withdrawal in the future.

The same applies to an additional rate taxpayer.

This exact point is one of the most compelling points about investing in a pension vs ISA.

Particularly if your employer matches your contributions. More on this later.

Note that the maximum amount that you can contribute to your pension and receive tax relief on is 100% of your annual pay up to a maximum of £40,000.

ISA

Stocks and Shares ISA act as a tax wrapper, so you get tax-free growth in your investments and don’t pay Capital Gains Tax (CGT).

For Cash ISAs, you get a Personal Savings Allowance (PSA).

Basic rate and higher rate taxpayers don’t pay tax on interest up to £1,000 and £500 respectively.

Note though that you don’t get tax rebates when you put money into an ISA as you do with a Pension.

So the growth in your money will not be as powerful simply because you’ll have less money in your ISA compared to a pension contribution.

Note also that an employer cannot contribute to your ISA, whereas they can into your pension.

Where a pension can accept up to £40,000 per annum, the most you can put into an ISA is £20,000 per person.

INVESTMENT RETURNS

Pension

Where your money is invested with your pension and the type of assets it is invested in will dictate the extent of your investment returns.

If you have an employer pension, it is worth checking what the asset allocation is for your pension depending on what your risk appetite is.

In many cases, many people ignore this element and their pensions suffer from high fees and low returns over many years.

If your pension is invested properly and by this I mean invested broadly across various asset classes and globally diversified, you could on average generate returns of anything between 4% and 8% per annum.

These returns will be driven by the extent of asset allocation broadly between equities and bonds.

The higher the allocation to equities over a long enough horizon, the more likely that you would generate high returns.

Note that you can make some predictions about what your future pension might look like by using a pension calculator.

Related post:

How to Start Investing In The Stock Market For Beginners

ISA

Given there are different types of ISAs the type of returns that you can generate varies.

For example, a simple Cash ISA only gives you the returns that you can generate from savings in your bank account.

These tend to be quite minimal in the low-interest environment that we are in.

A Stocks and Shares ISA gives you a lot more potential to generate higher returns because you can invest your money in a broader range of assets including equities and property.

By doing so you are more likely (depending on your asset allocation) to generate returns in the range of 4% to 8% on average.

Another type of account is the Innovative Finance ISA (IFISA), which is used for investing via peer-to-peer lending.

These types of investments tend to focus mainly on business loans or loans for property development projects.

As such, it is a higher risk than leaving your money in a cash ISA and higher risk than investing your money via the stock market in index funds and ETFs.

This type of investment sits between cash and equities and can offer returns of up to 10% per annum although you could also lose your entire investment.

Related post:

The Ultimate Guide to Peer-to-Peer Lending

RISKS & REGULATORY CHANGES

Pension

Most people's wealth in the UK is either in their pensions or in their properties.

Pensions have historically been are an area that successive governments have used through various changes to fund their policy commitments.

This means that pensions are easier and will be a lot more likely to experience changes in the future that could be detrimental to savers and investors.

In fact, it’s pretty much inevitable that in the years to come you’ll see significant changes to pension rules that will work against you and me as savers and investors.

ISA

ISAs represent a much smaller pot of money in comparison to pensions.

It is also a lot more flexible because you and I can easily access our money at any time.

As such it is a lot less likely that future regulatory changes will affect ISAs negatively.

A good indication of this is the fact that the trend remains upwards for how much we can contribute to our ISAs every year.

As mentioned before, the current allowance is £20,000 per person per annum.

So a married couple, for example, can contribute to a total of £40,000 into the ISA tax-free.

INHERITANCE

Pension

One of the often-overlooked benefits of investing in a defined contribution pension is the impact that it can have on the inheritance of your loved ones.

If you die before the age of 75 and have money in a defined contribution pension, it can be inherited by your loved ones tax-free because it will fall outside of your estate for inheritance tax purposes.

However, if you die after the age of 75, the beneficiaries of your pension pot will have to pay tax at their marginal rate of tax.

ISA

Your ISA is counted as part of your estate for inheritance tax purposes. As such, your beneficiaries are likely to pay inheritance tax on your ISA savings.

Under new rules, your ISA but can be passed on to your spouse or civil partner whilst keeping the tax benefits and without paying inheritance tax on it.

How to Invest Money: EMPLOYEES (Basic and Higher rate taxpayers)

If you don't work for a company where your employer matches your pension contributions, then I would suggest investing your money in this order:

1. Invest your money through a good quality stocks and shares ISA account.
2. Then consider investing your money through a dealing account so that you can use your annual capital gains allowance currently at £12,000.
3. Invest through a pension but ideally through a Self Invested Pension Plan (SIPP) so that you can monitor your fees and investments.

If you are a basic or higher rate taxpayer who works for a large company where your employer fully matches your pension contributions, then this is my suggested order of investing:

1. Maximise investing through your pension because you are in effect getting a 100% return via your employer matching your contributions.
2. Invest through your Stocks and Shares ISA and increase access and liquidity.
3. If you have any money left, then invest through a dealing account and use your annual capital gains tax allowance currently £12,000.

Note that the above assumes that you’re ok to wait till the age of 55 in order to access your pension.

How to Invest Money: EMPLOYEES (Higher rate or Additional rate taxpayers)

If you’re a high earner whose employer does not match his or her contribution it is still worthwhile considering to invest in this order:

1. Maximise investing through your pension because you also get a 50% top-up on your contributions.
2. Invest through your Stocks and Shares ISA and increase access and liquidity.
3. If you have any money left, then invest through a dealing account and use your annual capital gains tax allowance currently £12,000.

Notes that the returns from investing in this order as a higher rate taxpayer could potentially outweigh the risk that your pension might be subject to future regulatory changes.

This suggestion assumes that you’re ok to wait till the age of 55 to access your pension and you have no urgent need for your money before that.

How to Invest Money: ENTREPRENEURIAL ROUTE

If you are considering going down the entrepreneurial route of starting your own business, then this might be a suitable order to invest in:

1. Maximise your current Stocks and Shares ISA allowance of £20,000. The reasoning here is that you’re more likely to have a need to access your cash as a new entrepreneur.
2. Contribute via a dealing account and use up your annual capital gains allowance of £11,000.
3. if you have any more money left then contribute via your pension. this can be done from a limited company and counts as an allowable expense.

Related post: Self-Employed Pension: 9 Retirement Savings Hacks

In conclusion…

The choice of whether to invest in a pension vs ISA really depends on your personal circ*mstances.

For example, I chose to prioritise investing through my ISA first and then focused on making overpayments on my mortgage and then invested excess cash via a pension (SIPP).

We chose to do it this way because we are in my mid-30s and gave more priority to the need to have access to our money quicker than wait until we are 55.

This was driven mainly by the need to live a more flexible lifestyle.

In any case, we invested via both an ISA and a pension simply because our income allowed us to do so.

You will have to make the same assessment for your own personal circ*mstances in order to decide which of a pension vs ISA should take priority and work for you.

The fact that you might be considering investing in a pension vs ISA, in any case, is a good indicator as the current average savings rate in this country is very low.

I hope the above has been useful in helping you make the right decisions about your own personal financial life.

What To Read Next >>

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• How To Invest Money For Financial Independence In 10 Years

Are you currently investing through an ISA or through a pension or both? Please comment below and let us know what your justification for your preferred route of investing your money.

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