With the recent shake up to pensions and some changes to ISAs there has been a lot of talk as to where your long term savings are best accumulated. The answer is... it depends.
Where ISAs are NISA
The ISA investment limit is currently £15,000 and is set to rise to £15,240 from April 2015. From July last year the ISA was also reformed into the NISA removing the previous restriction of only being able to invest up to half in cash. It is now possible to invest in any combination of cash or stocks and shares.
ISAs do not offer tax relief on the initial investment but subsequent income generated is tax free. This is in contrast to pensions which offer tax relief on the way in but are taxed on the way out. If you are likely to want to make sizeable withdrawals on retirement then ISAs may be the way to go.
Unlike a pension, ISAs can be accessed at any time so if there is a chance you will need to dig into your savings before turning 55 the ISA will win the battle.
In the 2014 Autumn Statement, the Chancellor announced that ISAs can now be passed on free of tax on death to the surviving spouse. The funds can be transferred into their ISA with an additional allowance for that year equal to the value of the deceased’s ISA.
Previously if the surviving spouse had already used their full limit or if the funds were higher than the annual limit the tax benefits would be lost. However, with death tax changes also introduced on pensions as detailed below, ISAs are up against firm competition.
Where pensions win out
Higher and additional rate tax payers are likely to be the main winners for pensions. Currently tax relief at 40% or 45% will be received when paying into a pension. On retirement you could receive 25% as a tax free lump sum and, providing you only receive a pension up to the basic rate band, will pay 20% tax on the remainder.
At the present time, it is generally only possible to pass a pension on as a tax free lump sum if you die before the age of 75 and you have not taken any tax free cash or income. Otherwise, any lump sum paid from the fund is subject to a 55% tax charge. From April 2015 this will change, and this automatic tax charge will be abolished. The tax treatment of any pension you pass on will depend on your age when you die, but will be completely tax free if it is before you reach 75.
Pensions are victorious over ISAs here as it is passed on tax free to any beneficiary, not just the spouse. However, if you are in good health and likely to live past 75 any drawdown will be taxed at the marginal rate of the recipient which could tip the scales back slightly in the favour of ISAs. Pensions will also offer a lot more flexibility for draw-down from April 2015 and can be accessed from the age of 55, as wished, or left for the next generation.
Removing previous restrictions of drawdown has received positive reactions from most and the flexibility afforded leaves them not too far behind ISAs in terms of accessibility.
Pensions also win on inheritance tax as they generally fall outside of the estate whereas ISAs do not. If the ISA is passed on to the spouse on death a tie may be called as it will be exempt from inheritance tax. However, on the second spouse’s death it will form part of their estate and inheritance tax may become due.
The best approach will depend on personal circumstances but the imminent changes on pensions are likely to place them in pole position to provide the best tax advantages for most.