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which is better: ISA or pension?

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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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18 comments for “which is better: ISA or pension?”

  1. Not sure how true this is, but from a risk point of view, I “think” that investing in a pension protects it if you become financially unstuck, whereas ISA and other personally managed funds could be at risk if you get into financial difficulties.

    Posted by Llama for brains | January 4, 2008, 3:11 pm
  2. I am going for ISAs and I am workingon selecting a share ISA provider. Nothing on pension so far.

    I want to investigate the pension option in a near future as it seems to allow me to optimise my current tax situation. I still have some big questions regarding to what will happen later with the pension option as I am a French native.

    Posted by JF | January 4, 2008, 11:29 pm
  3. Ugh. Basically if you live in a Western nation whose capital city is not Washington DC you probably have better health, pension, retirement, tax, etc. benefits. I am just going with plain vanilla brokerage account savings, which is hardly any kind of retirement-advantaged plan. It’s a shame. I think the US could tweak the tax code in such minor ways to encourage saving. Even health care could be fixed pretty easily - but it would require higher marginal income tax rates.

    Sorry for the mini-rant…!

    Posted by Brip Blap | January 5, 2008, 12:53 am
  4. @Llama for brains:
    A pension does provide more protection in bankruptcy. An ISA would certainly be taken by the trustees, but according the Pensions Advisory Service

    “The Welfare Reform and Pensions Act 1999 protects all pensions arising from tax-approved pension schemes against being part of a bankrupt’s estate, for anyone made bankrupt after 29 May 2000″

    If you’re in an IVA, it seems as if that won’t affect the pension that you’re currently in, although you may be asked to stop making contributions for the duration of the agreement. Any ISA is likely to be taken by the creditors.

    According to the Pensions Advisory Service, It looks like you can transfer pensions overseas to qualifying schemes, there are a handful of French schemes, mostly Plan d’Epagne Retraite Populaire, that are currently qualifying schemes.

    @brip blap:
    I’m not really in a position to comment on the US tax/benefits system, but it certainly seems less generous than elsewhere.

    Posted by plonkee | January 5, 2008, 2:33 pm
  5. Thanks plonkee.

    I have accounts with 2 banks in France but none of them got a PERP recognized. Time to send some emails :)


    Posted by JF | January 5, 2008, 4:11 pm
  6. I’m currently filling my ISA for the year and have just started looking at pension plans, with the goal of getting something started in 2008. (Personally I see the two as completely separate funds, not an either/or case.)

    It’s been suggested to me that a good option is to buy property to let over the same period I would normally be pay into a pension plan, then use that to fund a retirement plan instead. It would be great to see a similar post on property vs pension plans to help make my mind up!

    Posted by Nick | January 5, 2008, 5:00 pm
  7. Interesting thoughts Plonkee - both have their meris of course, and as you say, it really depends on your personal situation as to how much you invest in each.

    I’m looking to increase my pension contributions this year - I also have an ISA running, but that is intended to pay off my mortgage. The big problem with the ISA is the accessibility of the cash - very tempting to dip into it from time to time - the pension has the edge there, as the money can’t be touched.

    Posted by Rob Lewis | January 6, 2008, 8:33 am
  8. @Rob:
    Yes, it’s always difficult to maintain the discipline of not touching the money, and the pension restrictions are good at forcing savings.

    My current trick round that is to track my investments together, and just pretend that none of them can be touched. It’s working so far, but we’ll have to see how it does in the future.

    Posted by plonkee | January 6, 2008, 9:06 am
  9. It would be a great folow-up to see which way you go!

    Posted by RacerX | January 6, 2008, 9:23 am
  10. I’m in the fortunate postion of having a final salary pension so I don’t feel compelled to invest more money into a personal pension as well.

    However I tend to invest the maximum into an ISA each year for the flexibility it provides.

    Although the tax benefits of a pension are impressive you do pay for it in restrictions.

    I don’t like the idea of being forced to buy an annuity and I don’t like the idea of being told when I can access my money. I also don’t like the idea of the government changing the rules in the decades before I retire. I don’t like the idea of being told when I have to retire - what if I want to stop work when I’m 50?

    For these reasons I will continue to keep the bulk of my money outside of pension funds.

    Posted by Matthew | January 6, 2008, 8:06 pm
  11. @Matthew
    I’m also not a fan of the rules changing adversely, but since you no longer have to buy an annuity - and until you’re 75 it’s reasonably straight forward not to.

    You’re quite lucky to have a final salary pension, I’d keep an eye on the pension trustees and so on though, just to make sure that they’re not messing it up.

    Are you investing any money on top of an ISA? (if you have the money to spare that is)

    Posted by plonkee | January 6, 2008, 8:33 pm
  12. I’ve come to this one late, thanks so much for it plonkee! I share concerns/opinions with so many of the other posters here-concern about lack of protection, being in a final salary pension anyway (as well as a stocks growth one), REALLY concerned that the rules will have changed once the baby boomers have stopped gorging at the trough, etc.

    Pensions don’t work for my situation (enough to invest more money in them), but I do think they’re a great idea generally, and all power to people who use the opportunities they afford. I’m really glad that I’ve got pensions, not so much for the amount they hold, but because they’ve taught me important financial lessons such as being less risk averse, and to think more sensibly about the future (in my case, to live a little and not just hoard every cent/penny- I think for most people it works the other way!).

    Posted by Pippin | January 8, 2008, 5:57 pm
  13. The risks to a pension are essentially the same as the risks to any investment in the stock market. The pension is just the tax wrapper that you put it in.

    The only other thing is about when you are allowed to access the money - and that has changed, but on the other hand, the longer it stays there the more chance it has to grow.

    Posted by plonkee | January 8, 2008, 7:43 pm

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