1. If you want tax-efficiency
Both ISAs and pensions are a tax-efficient way to invest. They work in slightly different ways though.
When you pay into a pension you get tax relief on any contributions you make (up to the annual allowance) at the highest rate of income tax that you pay.
When it comes to drawing your pension, there may be tax to pay though. (see No. 5 for more information).
Where ISAs differ is that they don’t allow you to claim tax relief on money going into them, but they do give you total tax exemption on any gains made within the ISA. So however much you build up in an ISA over the years, you won’t pay a penny of tax on any of it when you come to withdraw it (certainly not under current ISA rules any way).
The truth is that if you’re in a company pension scheme and get a contribution from your employer, that ‘free’ money coupled with the tax relief pensions attract, makes a traditional pension hard to beat.
Plus from April 2019 a combination of the employer contribution plus the tax benefits on a pension will deliver a return of 70% on a net contribution for a basic rate taxpayer under automatic enrolment. . Even if you don’t receive employer contributions, as a higher rate tax payer a pension or SIPP still tends to be a better choice.
And it trumps a Lifetime ISA in the majority of cases even if you get the £1,000 a year bonus on the maximum investment of £4,000 a year.
2. If you want flexibility
Pension savings are locked away until you’re at least 55, whereas with a stocks and shares ISA you can get your hands on your money whenever you want to. A Lifetime ISA though shouldn’t be touched until you’re 60. Withdraw it sooner and you’ll lose the bonus and any interest earned on it. The one exception to the age 60 rule is if you’re diagnosed with a terminal illness. Then you’ll be able to withdraw your money including the bonus.
So, if you already know you’ll need the money you’ve invested before the age of 55 - maybe because you have a mortgage to pay-off, school or university fees to pay for, a wedding to contribute, or whatever else you know lies ahead, then putting that money into a pension is a bad idea. In that case a regular stocks and shares ISA is your better option.
Similarly, if you don’t know you’ll need the money for sure, but have a sneaking suspicion that you might, or just want the comfort of knowing you have some money to hand should you need it, then splitting your potential investments and putting some into your pension and the rest into an ISA might be a better idea.
3. If you want to keep your money out of temptation’s way
The fact that pension investments are locked away until you’re at least 55 (or 60 if you go down the Lifetime ISA route) is as much of an incentive for many investors as it is a deterrent for others (see no 2 above).
The fact that you have to leave your money invested over decades also comes with its own rewards. Not only does long-term investing have the added benefit of allowing time to iron out any dips or blips that may affect investments held for a shorter time, but there’s also the power of compounding to factor in.
Think of it like a snowball effect. Not only can your pension contributions start growing as soon as they’re invested and continue to do so - barring the odd hiccup along the way - but the compound effect means that as your pot of money grows, so does the effect of all those additional contributions and the gains that earlier contributions have already made. It’s not for nothing that Albert Einstein called compounding the eighth wonder of the world.
4. If you want to invest more than £20,000 a year
The annual ISA allowance is currently £15,240 a year, rising to £20,000 a year from 6 April. The maximum you can contribute to your pension and get tax relief on is £40,000, although if you’ve already started drawing a pension, you will only get tax relief on a maximum of £10,000 a year.
Remember too that the annual allowance applies across all of the schemes you belong to. It’s not a per pension scheme limit, so if you have numerous pensions in your name, all the contributions you make to any of these pensions count towards the annual limit. So do contributions made by your employer, so make sure you don’t breach your annual allowance.
If you are going to breach the annual allowance, maxing-out your pension contributions first, before saving into an ISA, is a good way to take best advantage of the tax perks on offer.
5. If you’re relying on a lump sum to clear your mortgage
Since the so-called 'pensions freedoms’ came into being, increasing numbers of people have seized the opportunity to get their hands on a tax-free lump sum when they reach the age of 55.
If you plan to do this, make sure you know the rules. You can take up to 25% tax-free, but further sums, which are classed as income for tax purposes, may incur income tax if your total taxable income falls into the basic rate tax band or higher.
The government’s Pension Wise service offers free, impartial guidance to help you understand your options at retirement. You can access the guidance online at www.pensionwise.gov.uk or over the telephone on 0800 138 3944.
Fidelity’s Retirement Service also has a team of specialists who can provide you with free guidance to help you with your decisions. They can also provide advice and help you select products though this will have a charge.
Withdrawals from an ISA don’t incur tax, no matter how much you take out of the pot.
Emma-Lou Montgomery, Fidelity Personal Investing
Emma-Lou is an experienced financial journalist with over 20 years’ experience working in the national and online press. The former editor of Shares magazine and Moneywise and editor-in-chief of Interactive Investor, she has also worked for The Telegraph and the Evening Standard, Bloomberg Business News and BBC Radio 5 Live.
The value of investments and the income from them can go down as well as up, so you may not get back what you invest. Eligibility to invest into an ISA or pension and the value of tax savings depends on personal circumstances and all tax rules may change. With a pension you will not normally be able to withdraw money until you reach the age of 55. The information on the Lifetime ISA is based on our understanding of the proposed rules which may be subject to change. This information does not constitute investment advice and should not be used as the basis for any investment decision nor should it be treated as a recommendation for any investment. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity. Fidelity Personal Investing does not give personal recommendations. If you are unsure about the suitability of an investment, you should speak to an authorised financial adviser.