plonkee money an english-er's thoughts on personal finance

January 4, 2008

which is better: ISA or pension?

Filed under: investment — Tags: , , — plonkee @ 12:00 pm

Yesterday I posted about how I’d spent all my money last year. In the comments Pippin pointed out the following:

You’re also not using your full ISA allowance! OK, you’re putting a lot into pensions which do attract better tax breaks, but it does mean surrendering control of your money. (for me, I’m happier, and my calcs suggest I’m better off, loading up ISAs rather than locking away in a pension.)

Stocks and shares ISAs and pensions are both forms of tax-advantaged wrappers. In particular, they can be wrapped around a variety of investments, including my favourites, index funds.

what’s the difference?

The main difference between an ISA and a pension is that you invest with pre-tax money in the pension, and are taxed on withdrawal, whereas with an ISA you invest with after tax money but can withdraw tax free.

In addition, you can put less money in an investment ISA than in a pension, but you may access your money whenever you like, whereas with a pension you can only access the money once you reach retirement age.

If your tax rates stay the same throughout your working life, there won’t actually be any difference in the final value of either an ISA or a pension, assuming that you invested the same amount in each and they had the same fees.

what should I consider?

Deciding which is better to invest through, like everything else, depends a lot on your circumstances.

I’ve got one pension through work, and my employer doubles the contribution I make, up to a maximum of 1.5%. I’d be a fool not to take that, as it’s a 300% return before it’s even in the stock market. If your employer does something similar then I strongly suggest that you start with that.

Otherwise, you need to consider whether you think your tax rates are likely to be lower or higher in the future. If they will be lower, then a pension would be better (as you’re paying tax in the future), if higher, then an ISA would be better (as you’re paying tax in the present). Of course, it’s impossible to know for sure, so some people suggest that you diversify for tax – or in other words, put some into both.

Another thing to consider is that you can only invest a few thousand in an ISA each year (£4000 – £7000 depending on whether you have a cash ISA), whereas you can put your entire earnings each year into a pension. Since your ISA allowance is use it or lose it, it might be better to invest in that up to the maximum (after taking advantage of an employer match).

There’s a maximum amount that you can hold inside a pension, and none at all for an ISA. If you think you’ll reach the limit before retirement, then an ISA contribution may be better. Also, since you can access your ISA money at any time, it’ll come in handy if you plan to retire before standard retirement age (50 increasing to 55 shortly).

If you’re looking for more detailed information on the various rules associated with pensions and ISAs, the definitive source is Her Majesty’s Revenue and Customs (HMRC) – the taxman.

what are people doing in 2008?

In 2008, I’m planning to increase my stocks and shares ISA contribution, and either decrease or stop my private pension contributions. It’s a little more complicated as I’m trying to get enough in my private pension to transfer to a cheaper provider, but once I’ve done that, my 2008 investments will be focussed on my ISA.

I’m not the only one who’s reviewing their tax wrappers for 2008, brip blap is also looking outside retirement accounts, although the choices in the US don’t seem to be quite as good.

What about you? Do you diversify between pre- and post-tax investments, or between retirement and non-retirement accounts? 

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