Ever since the introduction of the ISA, there has been a debate about which is the better savings vehicle – an ISA or a pension.
It is, of course, possible to be in a pension scheme and pay into an ISA at the same time and it is great if you can afford to do so. But, for many people, on a purely practical level it is necessary to choose one or other savings options – based on their individual circumstances and wishes/plans for the future.
The main difference between a pension and an ISA lies in the way they are treated for tax purposes
Pension contributions attract tax relief at your highest marginal rate on the way in, as it were, with on the way out most of the eventual pension pot of money you have built up subject to income tax in the normal way. Also, normally you will not be allowed to access your money before age 55.
With an ISA the situation applies in reverse. The money you pay in does not attract tax relief, i.e. is paid from your after-taxed income, but then the proceeds of your saving are not subject to income tax on receipt. You can also usually access your cash at any age as you wish.
Conventional wisdom is that a pension plan should be viewed as a valuable long term savings vehicle to provide for yourself in later years with the money locked away for you for the future (from age 55 at the earliest). An ISA is more flexible, allows you to draw money out when you need it and is therefore useful to have for shorter term needs, emergencies or as a rainy day fund - but without the benefits that a long term investment can deliver.
"Although the waters have been muddied somewhat by the arrival from next year of the Lifetime ISA I would personally still hold to the view that a workplace pension is the best option for long term saving."
Although the waters have been muddied somewhat by the arrival from next year of the Lifetime ISA (see below) I would personally still hold to the view that a workplace pension is the best option for long term saving. Not only do you get tax relief on your contributions at your highest tax rate but you have the benefit of an employer’s contribution as well.
You will not get the benefit of an extra employer’s contribution, of course, if you are self-employed and have to take out a personal pension or a SIPP but you will still get tax-relief on your contributions at your highest rate and with a SIPP you will have extra investment opportunities for your money including for example in commercial property.
The Lifetime ISA announced in the Budget will be available from April 2017 to anyone aged 18-40 and you will be able to pay into it until the age of 50. You can pay up to £4,000 a year into it and the government will give you another £1,000. This is the same amount as you would get in a pension plan as a standard rate taxpayer and is therefore in direct competition with an unsupported personal pension when the contributions are made by a standard rate taxpayer and do not therefore attract relief at the higher rates.
The Lifetime ISA can be used to buy a first property costing up to £450,000 or be taken tax-free from the age of 60. It should be noted, however, that earlier withdrawals (other than to buy a house) will lose you the government bonus and you’ll have to pay a charge of 5% of the money you’ve saved. This is without a doubt, quite a hefty penalty.
In relation to a pension plan, the government bonus on the Lifetime ISA may also not be quite as good as it sounds given that it is only paid up to the age of 50 at which point it stops and you cannot get the money out for another ten years. With a workplace pension, by contrast, you get tax relief throughout the entire period you are saving, and you can get the cash out from the age of 55.
Echoes of the Pensions ISA
The Lifetime ISA appears to have echoes of George Osborne's alleged original plan to introduce a Pensions ISA which would in my view have massively changed the pension system as we know it to the detriment of long term pension saving as a whole.
As this new arrangement sits on top of and doesn't fully replace the current pension system, those dangers are to some extent lower than they might have been. Even in its present form, though, the Lifetime ISA could cause large numbers to turn their backs on pensions and seriously undermine the success of auto-enrolment which has been so marked to date.
As the auto-enrolment programme enters a critical phase with the take-on of the UK’s smallest employers there have to be doubts and worries as to whether the introduction by the government of the Lifetime ISA as a potential competitor is a wise move at this juncture, but only time will tell.