Pensions and ISA’s are a great way to protect your hard earn money from the taxman. When you invest into either an ISA or a pension fund, you pay no tax on the growth and no tax on any dividend income. The good news, both are great investment platforms that you should be taking advantage of, but they also have limits that you need to be aware of before you start planning your investments.
As a general rule, you can pay £20,000 a year across all the various kinds of ISAs that are now available as an individual, or £40,000 as a couple. For a private pension, it gets pretty complicated, but it’s about £40,000 per year (£32,000 personal contributions + £8,000 tax relief) that you can save. There is also a lifetime allowance in place which is currently £1,073,100. Above this figure, you’ll pay tax on all contributions.
ISA Vs. Pension
The critical difference between an ISA and Pension comes down to one thing, when you can have access to it. Pensions have been developed over the last few years, but you still cannot access money tied up in a pension, until your 55 years old, at the time of writing. The further bad news, this will rise over the next decade to 57 or possibly even 60.
ISA’s are slightly different. Effectively they’re like a tax-free bank account at you can have access to as when you choose. If you have a £20,000 ISA balance and you want to take out £5,000, it can be as quick as few buttons and a couple of days to transfer the money into your bank account.
What’s It For
At the end of the day, deciding on whether its best to invest more into your ISA or your pension comes down to whether you’re saving money for the long-term or the short-term. If you cannot access it, you cannot spend it and therefore are more likely to save it for your retirement.
With an ISA, you can access the money as and when you need it. This is a problem as most people will spend it and therefore, lose the benefits of investing over a long period. Remember, to really make money on the stock market, you need an investment time horizon of thirty years to allow compound interest to grow your money.
If you’re thinking to use this money to bolster your pension fund, it’s probably a good idea that you cannot access in the short-term; otherwise you’re likely to spend it.
Both an ISA and a pension are capital gains free. In other words, you’ll pay no tax on the growth of your money over time. When you start taking money out of your ISA and Pension, the rules are slightly different. With an ISA, you will use money that’s already been taxed to fund it, and you will pay no tax on any money that you take out.
The same cannot be said about your pension. When you take a monthly income from your pension, it will fall as part of your personal income allowance. As of current rules, this would mean that you’re allowed £12,500 tax free, after which, you’ll pay 20% tax on any income you take out of your pension between £12,501 and £50,000.
After reading the above, you probably think that an ISA is the way to go. Paying tax on your pension income is not something you wanted, but one important issue could flip the balance in favour of a pension. This is having access to a company pension fund that matches contributions.
In my case, I have a company pension where my employer contributes with the minimum allowed by law. As a result, I pay in 5% of my salary into my pension, and my company pays in 3%. The important point, to remember, this is free money and an instant 60% return your money. 5% and 3% is generally the minimum allowed by law, but uncommon to for an employer to match your contributions. If your company will allow you to pay 10% of your salary into a pension fund, and match it with the same amount, this is seriously worth doing.
In the unlikely event that the bank or building society where you’re holding your ISA or pension, falls into financial difficulties, the rules are very different in terms of compensation.
- For an ISA, you would be protected for up to £85,000 per institution under the Financial Services Compensation Scheme (FSCS) unless it’s a stocks and shares Isa where you will only be covered up to £50,000 per person.
- For a pension provider, such as an insurance company, the FSCS will payout 100% of your claim with no upper limit.
- For SIPP’s, customer funds are by law, required to be ring-fenced from the Sipp provider’s own account.
As the rules stand, inheritance tax is due on everything above the £325,000 limit, although if you die before the age of 75 and you have a defined contribution pension, it can be held outside of your estate and can be passed on to your beneficiaries completely tax-free. ISA’s are part of your estate and added to other savings and assets when you die.
If you’re going to investment money into an ISA, it makes sense to spread your money across different providers if you start to exceed these amounts. One point, make sure you’re going to different banks, and not different arms of the same group. The FSCS will only pay out £85,000 per person for each FCA-authorised institution.