ISAs v Pensions: The Official Retirement Debate

Easy cases first, where there is little to no disagreement even among those who routinely disagree:

1. Get a state pension forecast and arrange enough pension to total at least 8-10,000 income in retirement. This exploits the tax benefit paying in and lower tax taking the money out in the 0% and 10% bands.
2. Arrange that 8-10,000 for both partners if you're a couple, to exploit both tax allowances and provide a cheaper pension income for your partner after you die, by avoiding the need for a dual life annuity or long guarantee periods.
3. Take any employer matching funds for a pension up to the employer limit.

The rest is down to personal views on various factors:

1. A higher rate tax payer who will be basic rate in retirement gets a tax benefit from the pension.
2. The 25% tax-free sum is a benefit only available from the pension and it gains from the tax rebated on the way in. It's also unpopular in some government circles so it carries legislative risk of being eliminated.
3. The pension can't be taken before 55 soon, while an ISA can be taken at any time.
4. The amount that can be taken out of a pension in income drawdown is limited but the amount that can be taken out of an ISA isn't limited.
5. Annuities are the government-favored option for retirement income from a pension so alternatively secured pensions available after age 75 have a high legislative risk of going away. Age 75 is also the point at which an annuity is currently expected to be better than income drawdown for an average person, if you ignore inheritance concerns.
6. ISAs are fully inheritable across generations. Pension money has major penalties and limitations on inheritance across generations.
7. ISAs are savings. Pensions aren't. This is significant for those who may receive means-tested benefits during their working lives.
8. The pension rules on what happens to past contributions (but not their value) have routinely been changed by governments and this seems likely to continue in the future. ISAs may be eliminated but their future is probably less subject to legislative risk.
9. You can put up to your whole salary into a pension each year so using an ISA first if in doubt is a practical approach that can work even up to a few years before retirement.
10. An annuity or income drawdown pays more to those who live longer. Historically, this means that manual workers and those in the north of England and Scotland get less from their annuities than those in desk jobs and from the south. Those who can expect a short retired life may benefit from ISA funds and more rapid withdrawing of them. The problem with this is the chance that you may live longer than expected and may be poorer for a long time after the ISA money is gone.

Place your bet on what future governments will do to pensions and whether the current and possibly greater reduced flexibility of a pension will be more or less costly than the tax treatment.

Those commenting here seem to prefer the greater control of the ISA approach up to the ISA limit.

Note on 18 Feb 2012 in reply to a private comment asking: this is still my current summary. No significant changes to it. Similar for the comment by dunstonh a few posts later, aside from the 22% tax rate mentioned in that one.

Having always been self employed I have frowned upon pensions as you never know what is round the corner - you may need some of the money in a hurry and/or before retirement. I agree that if you earn enough part ISA and part pension is a good idea.

While on the subject of retirement, the government are always telling us to save for our retirement but never say how much. Has anyone any idea of a ball park figure to save for an enjoyable retirement?

Personally, I have both ISAs and Pensions.

Here are my thoughts to add to the debate.

(a) Take out a pension if your employer makes a contribution to it.

(b) Although you get tax relief on your pension contributions on the way in, the income you can take when you retire is taxed. Tax is deferred. This may be beneficial because:
(i) 25% of the Pension fund can be taken tax free
(ii) You have a personal tax free allowance on income
(iii) You may be a higher rate tax payer now, but a basic rate tax payer in retirement.

(c) If you are a basic rate tax payer, consider saving outside of a pension wrapper until you are a higher rate tax payer. Then transfer the investments to a pension to get the maximum tax relief.

(d) Save in an ISA to build up your tax free lump sum to use in retirement, rather than taking it from your pension fund. Discipline yourself to regard a certain percentage of your ISA fund as "retirement" savings and the rest as other savings.

Things that are the same:

1 - both have tax free growth
2 - both can invest in virtually identical areas
3 - charges can be exactly the same (although pensions do have a budget option with stakeholder)

Benefits of pension

1 - tax relief on contributions
2 - no inheritance tax to pay if you die before retirement as lump sum is outside of estate
3 - on death before retirement, the death benefits (value) will be 22% higher than an ISA
4 - not accessible until 55 (from 2010). Double edged sword for some but some need the tie in.
5 - contributions can increase your working/childrens tax credits received giving upto a potential equivalent of 72% tax relief

Benefits of ISA
1 - flexible. The lump sum is yours to do with as you wish
2 - income or fixed regular withdrawals in retirement are tax free
3 - on death after retirement, the lump sum is paid to beneficiaries
4 - If pensions get improved later or something better comes along, you can move your money into that.

Negatives of pensions
1 - Annuity compulsion. You have to purchase an annuity at some point. Ok, we have ASP and USPs but the Govt keeps fiddling with these so at this time, its worth having the mindset that you may be forced to buy an annuity
2 - income from pension annuities is taxable
3 - If you die after purchasing the annuity, the income can die with you (subject to spouse benefit and guarantee period)
4 - If you start the pension income early, the annuity rate is likely to be very low
5 - If something better comes along later, you cannot take the money out of the pension and put it into that.

Disadvantages of ISA
1 - Its too easy to dip in and you need to be disciplined.
2 - For the first £10k of income in retirement, the income from the ISA would be lower than what the pension would have provided.
3 - On death, the lump sum forms part of your estate and IHT could be payable.
4 - means testing can mean that ISAs are taken into account when looking at benefits but pensions are not (until they are commenceable)


Ideal scenario for a basic rate taxpayer is
1 - contribute to pensions to aim for a £10k income in retirement as this uses up the £7,280 personal allowance and £2150 10% lower rate band. (the pension tax relief at 22% is valuable in this case as you get 22% going in but pay nothing or just 10% coming out.
2 - always split your retirement planning equally between couples. You both have that £7280 personal allowance which is nearly £15,000 a year tax free income
3 - when your pensions are on track to give a real term income in excess of £10k, then switch to ISA

Notes to be aware of:
1 - self employed individuals only get the basic state pension of £4381. They do not get SERPS/S2P.
2 - Taxable income in retirement above £20,100 increases your tax burden. For every £2 above £20,100, your age allowance is reduced by £1. Income from ISAs does not count towards your taxable income. (savings account interest goes towards the £20,100 so dont be too heavy in cash).
3 - age allowances increase annually. So this £10k target could well be £15k in 10 years time and age allowance reduction £25k. Work in real terms (with inflation taken into account) to keep yourself on track.

When we talk about ISAs on the pensions front we refer to stocks and shares ISAs.

Cash ISAs are not suitable retirement planning vehicles as they are no good for long term planning.