Isas versus pensions

The difference is purely in the tax treatment of your underlying investments and it basically boils down to this question: "Should I take the bribe that is tax relief on pensions and forgo access to assets potentially for 30 or 40 years, or do I go for ready access in the Isa world and forgo the tax relief?"

Why are Isas so popular?

The Isa is easiest to understand because of its simplicity: You put your money in and it grows free of tax and you can then take your money out free of tax.

So it's not surprising that the Isa is the UK's favourite tax break, with 14.2m adult Isa accounts subscribed to in 2011-12, accounting for £54 billion of savings and investments. However, 80 per cent of this money was put into cash Isas. At the Investors Chronicle, we are more interested in stocks-and-shares Isas, which are higher risk, but where your money has better potential to grow. These are a better comparison with pensions.

According to HM Revenue and Customs, almost 3m investors subscribed to stocks-and-shares Isas in 2011-12, on average investing £5,473. However, this is small fry compared with the 5.7m people contributing to personal pensions in 2010-11 (the latest date for which HMRC has figures).

Isa basics

Individual savings accounts (Isas) were introduced on 6 April 1999, replacing the earlier personal equity plans (Peps) and tax-exempt special savings accounts (Tessas). Isas are tax wrappers into which you can put cash or stocks and shares. Any income received in the form of interest and dividends is free of tax and there is exemption from capital gains tax on any capital growth.

For the 2012-13 tax year the maximum amount that can be invested into an Isa is £11,280. You can put all of this allowance into stocks and shares. But the limit for cash Isas is half this amount at £5,640. So if you use your full cash Isa allowance, you would then have £5,640 left to invest in stocks and shares.

If you want to open a stocks-and-shares Isa you have to be aged 18 or over, whereas you can open a cash Isa when you turn 16. You also have to be resident in the UK for tax purposes, and you cannot hold an Isa jointly with, or on behalf of, anyone else.

Isas vs pensions

Both pensions and Isas deliver one-shot tax relief as well as allowing your savings to grow tax-free. Pensions give you the relief upfront, by rebating the income tax you would otherwise pay on your contributions. Isas give you the tax relief later, since you pay no income tax when you draw an income.

Many experts argue that pensions are better than Isas because the upfront income tax relief is more valuable - you have more money to compound over the years with a pension.

A pension contribution of £10,000 made by a basic-rate taxpayer only costs £8,000 after income tax relief. For a higher-rate taxpayer, the net cost is £6,000. This has the effect of guaranteed instant growth of over 25 per cent for the basic-rate taxpayer and 66 per cent for the higher-rate taxpayer - the equivalent of 30 years in the building society at current rates, but overnight.

To put these instant pension uplifts to your money into context, should you invest your £10,000 into a stocks-and-shares Isa and it performs well, growing at 6 per cent a year after charges, it would take more than four years to get a 25 per cent uplift and 11 years to get the 66 per cent uplift. In the meantime, your pension would have been galloping away, with the compounding effect of interest on the tax relief making it far the superior performer.

Plus, with a pension there is a second shot of tax relief - when you draw your pension you can take 25 per cent of the pot as a tax-free lump sum (most people take this option).

Don't underestimate how powerful the tax-free cash from pensions can be. You can then put the proceeds into an Isa, or drip-feed it into Isas if you have more than the allowance, thus setting up a tax-free income stream. Another thing that gives pensions the advantage for many investors who are employed is employer contributions. A workplace pension also often offers protection for your family in the form of income protection and life insurance.

The problem is that pension rules change with successive governments. The coalition has already reduced the annual pension contribution limits from £50,000 to £40,000. The lifetime allowance on pensions has fallen from a peak of £1.8m for 2010-11 to £1.25m for 2014-15. The removal of higher-rate tax relief on pensions is in the Lib Dem manifesto. So there are no absolute guarantees that you will get a 25 per cent tax-free lump sum from your pension in 20 years' time.

While governments could tweak Isas too, they are less of a target than pensions. The Treasury loses far more with pension tax rebates than it does with Isas, although that difference may diminish as decades pass and people build larger Isa holdings. Michael Johnson of the Centre for Policy Studies has argued that young people aren’t interested in pensions and will choose the Isa as their vehicle of choice.

Even today, Isas are immensely popular and you've received no tax benefit on the way in, so being taxed for just withdrawing your cash would seem a difficult sell to the public. Politicians could bring in a "lifetime allowance" after which you couldn't put any more in. However, the then Labour government tried this when they introduced, Isas but it was quickly rejected after the inevitable outcry.

So while you can cover your bases by using both vehicles, our money is on pensions being attacked further before politicians tinker with the Isa regime. But the killer argument in favour of Isas is that you can spend your money how and when you like. There are strict rules on what you can do with your pension pot, and when and how much you can withdraw from it.

Restrictions on drawing an income in retirement from pensions have created an intolerable situation for retired pension holders. You either have to buy an annuity - and rates are the lowest they have been in years - or you draw income directly via drawdown. However, the Government Actuary's Department (GAD) rate by which income drawdown limits are set has also dropped to unbearably low levels, meaning many pension investors can't get enough of their money out.

There is a flexible option for people who can secure £20,000 of income from a combination of state and private pensions. Once this is secured, under the flexible pensions rules you can draw the rest of your pensions as you wish.

However, the 'lock in' associated with saving into a pension is a big deterrent for many people. Once money is stashed into a pension, you can’t access any of it until you are 55, even if you have a financial emergency such as redundancy.

In December 2010, the government proposed allowing savers to dip into some of their pension funds early, but it since abandoned the proposals worrying that there would be too much temptation for savers to dip into pension for holidays or car upgrades.

So even though pensions can work very well if you are a higher-rate taxpayer while contributing and a basic-rate taxpayer in retirement, many investors find the lack of access demotivating.

How to use Isas and pensions

However, investors can still use a combination of (fully accessible) Isas and (locked in) pensions to build up flexible savings. Cash Isas can be converted to stocks-and-shares Isas when you feel able to take on more risk. Later on, when you feel able to lock your asset away, Isa subscriptions can be transferred into pensions (subject to the £40,000 annual pensions contribution limit) and receive income tax relief.

While, all things being equal, tax relief upfront (pension) is the same as tax relief later (Isa) from a pure maths standpoint, in your financial plans things are unlikely to be equal. The biggest difference to which route is best for you is a change in your tax rate. So you need to work pensions and Isas to best fit your personal circumstances.

Most people pay a lower rate of tax in retirement. This can make a pension a better option than an Isa for higher-rate taxpayers who will be lower-rate taxpayers in retirement, because the rate they pay on withdrawing the money will be lower than the relief they got when they put the money in.

There are no rules around which vehicle you use. Most people use both. It depends on personal preference. Younger people in the first half of their career may prefer an Isa. But for older people within 10 years of retirement, the pension may look more attractive.

You can convert an Isa to a pension at any time and benefit from the tax relief.

When comparing Isas with pensions, it is easy to overlook the fact that a £100 pension investment does not leave your pocket £100 lighter, as an Isa investment would. A basic-rate pension saver investing £80 in a pension and gaining a £100 investment could invest the extra £20 in an Isa and achieve even more tax efficiency. Higher-rate taxpayers could build up substantial additional Isa investments alongside their pension savings by doing so and, if kept for the long term, could add substantially to both the value and flexibility of their savings for retirement.

Lifetime & annual pension contribution allowances eligible for tax relief