Tax relief: The difference between pensions and ISAs

Stand aside pensions – ISAs are the new kid in town. That seemed to be the conclusion of a report published by the Office for Budget Responsibility (OBR), an independent body set up to hold the Treasury to account, last week.

And the evidence since 2010 certainly seems to back that assertion. George Osborne, the former Chancellor of the Exchequer, repeatedly wielded the axe to pension tax incentives, while simultaneously announcing dramatic increases in ISA allowances.

This series of reforms prompted the OBR to declare: “Broadly speaking, these [reforms] make pension saving less attractive and non-pension saving more attractive, particularly for high earners.”

So what exactly are the various pension and ISA tax allowances? How have they changed in recent years? And has the balance really shifted in favour of the ISA?

Pensions vs ISAs

Pensions and Stocks and shares ISAs are often pitted against each other as rival savings products, but in reality they operate in very different ways.

For starters, they are not taxed in the same way. Your pension contributions are tax-free, as is any investment growth on your fund, while you can take 25% of your pot out after age 55 without paying any tax at all. 

Any other withdrawals are taxed at your marginal rate, meaning the money is added to your earned income to determine how much you pay to the taxman in any given year. You might hear this regime described as ‘exempt-exempt-taxed’, or EET.

ISAs, on the other hand, are ‘taxed-exempt-exempt’, or TEE. This means there is no tax relief on money paid in, but investment growth and withdrawals are tax-free. 

Pensions also remain more restrictive than ISAs. Your pension will have to remain untouched until you hit your 55th birthday, the penalties for trying to break this rule are extremely severe. ISAs, on the other hand, can be accessed as and when you want, penalty-free.

Allowances

Both pensions and ISAs are subject to restrictions on how much you can pay in. The OBR documents the array of changes to both pension and ISA allowances since 2010. The annual allowance – the maximum you can save in a pension each year without paying tax – has plummeted from £255,000 in 2010 to £40,000 today.

And if you have income over £150,000, your annual allowance falls progressively to a minimum of £10,000 for those receiving £210,000 or more a year.

The lifetime allowance – a cap on the total value of assets you can hold in a pension – has also been pegged back, from £1.8m in 2010 to £1m in 2016. If when you come to take money out of your pension(s) your pot is worth more than this, you’ll be hit with a tax charge on the excess.

By contrast, the amount you can save in an ISA has increased during the same period, from just £10,200 in 2010 to £15,240 this year, with a further increase to £20,000 scheduled for 2017/18.

Changing of the guard?

Despite huge reductions in tax allowances in recent years, for most people – and particularly higher earners – the pension remains the most tax-efficient retirement savings vehicle available.

Pension tax relief – effectively a savings bonus from the Government – means the value of each contribution is instantly increased. So if you’re a basic–rate taxpayer, your £80 monthly contribution becomes £100 through tax relief. If you’re a higher rate taxpayer, you can claim another £20 through your tax return.

You can also pass on a pension tax-free to your loved ones if you die before age 75. If you die later than this, the money you leave behind will be taxed at your beneficiary’s marginal income tax rate. ISAs, on the other hand, are subject to inheritance tax.

While ISAs are more flexible and money taken out isn’t taxed, you don’t get a bonus from the Government for using them.

Even if you’re earning over £210,000 – and thus have an annual pension allowance of £10,000 – you should still seriously consider maximising your tax incentives, if you can afford to, before moving on to ISAs or other long-term savings vehicles.

So while it’s clear the tax tables have been tipped towards ISAs over the past six years, when it comes to saving for retirement the pension still sits at the top of the tree.