Workplace Pension Scheme vs ISA

An individual savings account or ISA is a tax free savings account. It's similar to usual savings accounts, but there is no tax to pay on the interest you earn with an ISA.

When it comes to opting out of a workplace pension scheme we feel that you need to know the whole story. If you're considering opting out of your workplace pension scheme to instead invest into an individual savings account (ISA), you'll need to weigh up the pros and cons. We've outlined these below.

Typically you'll see a better return on your investment by paying into a workplace pension scheme when compared to an ISA account. This is because pensions tend to have the edge when it comes to tax relief, leaving your capital to heirs, and has the added benefit that your employer pays in too.

Chartered financial planner Ammo Kambo says "If two people put the same amount into the same fund, one investing through an ISA and the other through a pension, the pension pot will be worth more" - Source.

Employer's contribution

With most workplace pension schemes every time you put money into your pension pot, your employer and the Government via tax relief does so too. For every £100 an employee puts in, your employer will put in £125, and the Government adds in a minimum of £25 (more if you're a higher rate tax payer). So an employee's £100 investment will result in £250 being added to their pension pot. More than doubling the employee's initial investment.

Which is best for tax relief?

Neither is 'best', when it comes to tax relief pensions and ISAs work slightly differently, we explain below.

Tax relief on ISA

Savings you put into an ISA have already had tax paid on them, so when you withdraw from an ISA you are not taxed. You're taxed on the way IN to an ISA but not on the way OUT.

Tax relief on pensions

Your savings into a workplace pension scheme are not taxed (providing you stick to your yearly and lifetime allowance), and you benefit from tax relief, which for higher rate tax payers is 40%. You'll start paying tax on your pension when you draw it at the standard rate of income tax, so pensions are taxed on the way OUT.

Why does this make a difference?

When you retire part of your income will fall into lower rates of income tax compared to your earnings when you were employed. Currently for the tax year 2015/2016 the first £10,600 you earn is tax free. What this essentially means is that;

  • Higher rate tax payers can earn 40% tax relief on pension contributions, but could end up only paying 20% or 0% tax when they retire. A gain of 20% to 40%.
  • Basic rate tax payers can earn 20% tax relief on pension contributions, but could end up only paying 0% tax for most of their withdrawals (up to the personal allowance of £10,600) and then 20% thereafter. A gain for most of 20%.

These gains are unmatched when compared to ISAs due to the way the tax paid. With ISA's the tax is already paid. Whereas with your pension you pay the tax later and are able to utilise the fact you'll likely be earning less and take advantage of your personal allowance and potentially lower tax bands.

25% tax free withdrawals from pensions

You're also able to withdraw the first 25% of your pension tax free, which again is unrivalled by ISAs.

Tax on death

While pensions and ISAs can be passed onto a spouse tax free, for inheritance tax purposes pensions remain outside your estate. What this means is that it is more tax efficient to leave your pension to your children or grandchildren when compared to ISAs.

Annual Limits

Annual limits on contributions for pensions is multiples of the amount that can be contributed into an ISA. Currently the limit for pensions is £40,000 per annum, compared to £15,000 per annum for ISAs.

Flexibility

The main advantage of an ISA is that access is more flexible in the sense that you can access it at any age, with most pension schemes you can't access them until you are 55.

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