Here we are at session number 80 , and we’re going to be answering one of the most frequently asked questions received by all financial advisers everywhere. Should I pay into a pension or an ISA? With recent pension changes, this is a more pertinent question than ever and one which merits its own session here on MeaningfulMoney.

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But first…

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Introduction

Huge recent changes to pensions means I am now being asked the pensions or ISA question more than ever. Which is best? Are there clear advantages of one over the other?

Everything you need to KNOW

1 – Recent changes to pensions

Recent changes mean pensions are more attractive than they have ever been:

• Unlimited access after pension age – More details at Session 53 
• Scrapping of the death tax from April 2015
  • Previously 55% in drawdown unless spouse or children (if eligible) take income – on all of it after age 75
  • Now tax free pre-age 75, and taxed as income to the recipient after age 75
  • Can be drawn down in stages – becomes their pension pot

2 – Similarities and Differences

Both ISAs and Pensions are just boxes – with different tax rules on entry and exit

Pension: Tax relief going in, tax paid going out, after Tax Free Cash lump sum has been taken

ISA: No tax relief going in, no tax going out.

There are some small differences as to what you can hold inside the boxes, but nothing material for most people listening to this. Once the money is inside the box, it is taxed in the same way:

• Free from Capital Gains Tax
• No reclaim of the 10% tax credit on dividends received

3 – Your tax status, both now and in retirement is a key factor

If you are a higher rate tax payer now, you get 40% income tax relief on your contributions, so £100 paid into a pension becomes £166.66.

If you are a basic rate tax payer now, you get 20% relief, so £100 paid in becomes £125

If you can get higher rate relief now, and only pay basic rate tax coming out, then that’s about perfect.

4 – Watch for other perks with company sponsored schemes

Contribution matching is something you’ll never get in an ISA, – common feature of company sponsored schemes, Free money from your employer has to be worth having!

Also consider salary sacrifice, which reduces the tax and NI burden for both you and employer. Sometimes employer passes on these benefits to you.

Everything you need to DO

Bearing those things in mind, let's look at what action steps you need to take to answer the Pension or ISA question unequivocally for yourself.

1 – Do the maths

The obvious question is how much will I end up saving in either a Pension or an ISA? It isn't too much of a mental leap to work out that if you’re being given free money by the governmnet you’ll be better off in a pension

How much? I've created a spreadsheet which enables you to put in a net monthly contribution, your starting age, an assumed rate of growth, and rate of contribution increase. It's far from perfect but might give you some idea of the sums you can expect to amass in both pensions and ISAs.

Download the spreadsheet here. (Right-click the link and choose ‘Save As')

Here's an example:

£250 pm over 20 years, with contributions increasing each year by 3%, and assumed growth of 6% would mean:

ISA: £148,508

BR tax payer pension: £185,635 (+ £37,127)

HR tax payer pension: £247,514 (+ £99,006)

2 – Establish when you need the money

If you are saving for retirement, it's a no-brainer: you should use a pension. If access to the money is needed earlier, then it has to be an ISA.

Of course, having both strings to your bow is the perfect scenario, funds permitting.

3 – Don’t neglect what is inside the box

Remember, pensions and ISAs are just boxes. The tax rules are just one factor. Also, what you put inside, what you’re invested in, and what your taxpayer status is when taking money out – all these are factors in the decision.

But in it all don't neglect the underlying investment inside the box. Take time to get this right, and the tax will look after itself.

4 – Bear Inheritance Tax in mind

Inheritance Tax (IHT) is often overlooked when it comes to pensions.

Unvested pensions, and from next year, vested pensions, will pass to loved ones tax free. This is a major benefit of pensions and should be borne in mind when making your choice.

ISAs on the other hand are always counted for Inheritance Tax, so if IHT is a problem, there are clear benefits to saving into Pensions.

Summary

I hope this has given you some things to think about. As always with personal finance, there are many threads to bring together when weaving a clear picture of what you should do. Circumstances, and tax rules change all the time, so it is important to keep on top of these as you go through life and head towards your target date.

As ever, you can leave me any questions in the comments section below or by voicemail at meaningfulmoney.tv/askpete

This week’s reviews

One review this week from 88macrae

If you like what you hear on this podcast, please leave a rating or review on iTunes by going to meaningfulmoney.tv/iTunes just like 88macrae did this last week. This helps others to hear about the show and to subscribe, because it keeps me near the top of the rankings.

News

Weight up to 16st 2lbs – I blame the conference I wen to last week. I have definitely plateaued since I cam back from holiday. Need to knuckle down now. One session at the conference was from Dr James Rouse. If you ever get chance to hear him, take it – he was superb. Also, a friend of mine called Sue has lost four stone, and I saw her for the first time in a few week yesterday and she looked amazing. Very inspirational.

Next Session Announcement

Next time we'll be talking about Advanced tax wrappers like VCTs, EISs and the like. These have become more accessible for ordinary mortals like you and me, and should be considered in your financial plans. If you have a question on this subject, or any other financial query that you want answering here on the show, then the best way to do that is to leave me a voicemail at meaningfulmoney.tv/askpete

Outro

That's it for this session of the MM podcast, I hope it was helpful. Please leave any comments below. I hope you enjoyed this session. Thanks for listening – I'll talk to you next time.