The world of pensions can be a minefield. There is a wide range of options available to individuals, with different tax implications and flexibility in the long run. However, two of the most common investment vehicles for retirement are ISAs and pensions. Which one will help you reach retirement the fastest?
Tax advantages
One of the biggest differences between a pension and an ISA is their tax implications. Put simply, a pension is back-end loaded when it comes the payment of tax. In other words, contributions are taken from gross salary and are not taxed.
In contrast, an ISA is front-end loaded. This means tax is paid on contributions before they enter the ISA. The result is that there is often a smaller amount invested during the build-up phase of an individual’s career.
However, withdrawals from an ISA are tax-free. In contrast, withdrawals from a pension are taxed in the same way as an individual’s normal income. Overall, there is no advantage or disadvantage to be had from paying tax at the outset or upon withdrawal. However, in many cases an individual will pay a lower overall tax rate in retirement as their income is generally lower. Alongside a 25% tax-free lump sum upon retirement, this may make pensions more attractive than ISAs from a tax perspective.
Flexibility
While ISAs may lack the tax advantages of pensions – especially for higher earners – they offer significantly more flexibility. Any money contributed to a pension cannot be withdrawn until the age of 55 (increasing to 57 in 2028). However, with an ISA the funds can be withdrawn at any time, for any reason, and at very short notice. For younger investors, this is a big plus because the money can be used to buy a house or other large capital item, for example.
While ISAs may lack the tax advantages of pensions – especially for higher earners – they offer significantly more flexibility.
Further, in the long run it would be unsurprising if the age at which a pension can be accessed increases. As mentioned, it is already increasing to 57 in 2028, and with life expectancies due to rise in the next couple of decades it may be the case that it is well above 60 by 2050.
Pragmatism
For many people, the incentive to contribute to a pension is increased because of their employment situation. Their employer may match their contributions up to a specific level, for example, or they may be a higher rate taxpayer. In those instances, pensions seem to be an obvious means of investing for retirement.
However, whatever your situation, having an ISA which is regularly topped up also seems to be a sound move. The tax disadvantages may be modest in the long run, while the added flexibility may be particularly welcome for younger investors seeking to buy their first home or move up the property ladder. Therefore, while it may not help you to retire any quicker, an ISA may make the journey less challenging.
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