As the new tax year approaches everybody over 18 resident in the UK for tax purposes will be able to take advantage of the increase in the ISA allowances up from £7200 to £10,200. This will enable couples to make a contribution of £20,400 a year into a very tax efficient investment. Cash ISA allowances go up to £5100 per year.

However with the increase also comes the age old question. 

Which is the best way to save for retirement – A pension or an ISA? 

Although there is a fair amount of advice on our website with regards to both pensions and ISAs, deciding which option is “best” is much trickier. As always it depends on the individual’s current situation as well as their goals and objectives. So please do not take this article as hard and fast advice, as it is only meant to offer guidance as to the main factors that need taking into account. 

I believe one way of arriving at an answer is to look at the actual figures depending on the age of the person starting the investment plan. If we take a male born on the 1^st March 1965 currently aged 45 who said he could afford £10,000 a year in contributions payable monthly – £833 per month. He is a 40% tax payer now and wants to retire at 65 when he is likely to be a basic rate tax payer and wants help deciding which is the best way to invest. 

All figures are rough estimates and presumes he dies at age 85 

Male born 01/03/1965 will pay for 20 years 

Pension + Small ISA

£833pm invested in a pension growing at 4.1% will potentially produce at age 65 a lump sum of £123,000 plus a taxable yearly pension of £24300 (this is dependent on annuity rates at the time and the type of annuity taken – we have presumed a level single person annuity with a guarantee for 5 years).

• Gross annuity income PA                     £24300
• Tax at 20%                                          - £4860
• Net income  PA                                     £19440
• Net pension income over 20 years =£388,800 

As a 40 % tax payer his tax code will be adjusted and he will receive £2500 extra in his tax allowance. Presuming he then invests this £2500 in an ISA for 20 years (he could of course also invest this in a pension).

• £208 pm into an Isa at 6% will produce a lump sum of £84600
• Presuming this pays a tax free income of 5% of £4230 after charges for 20 years.
• Income of £4230 over 20 years            £ 84600

His pension lump sum of £123,000 could be invested into a unit trust at 4% tax paid to give an income of £4920 pa.

• Income over 20 years £98400 

Total net income in retirement £388,800 + £84600 + 98400 = £571,400

Presuming no inheritance tax he will also leave his children  £207,600.

 Large ISA only

• £833 pm into an ISA only growing at 6% will produce a lump sum of £339000 
• The tax free income at 5% after charges of £16950 pa for 20 years
• Income £16950 over 20 years is £ 339,000 

To match the pension + ISA income of £571,400 he would then have to use £232400 of capital. (This capital withdrawal would also reduce the yearly income) 

Presuming no inheritance tax he will also leave his children (£339,000 – £232,400) an inheritance of £106,600. (This would also be reduced by the extra withdrawals) 

Summary 

In this case as the client was a  40% rate taxpayer who then became a basic rate taxpayer the pension + smaller ISA investment definitely wins. (He leaves his children over £100,000 more and gets the same income.)

However as he gets older on this  gradually changes in favour of the ISA. If he was a higher rate taxpayer in retirement this would also alter the figures. The returns on the different types of investment could also change the picture, as pensions have a wider choice of investment funds that can be used. 

In fact the investment returns and charges over 20 years will have a bigger part to play on the end result than almost everything else. The potential Inheritance tax issues also need to be taken into account before any decision is made. 

Essentially, there is no right answer for everyone as the calculations need to be carried out by an experienced financial planner.