Should you be investing more in your pension or ISA?

As much as we may want to invest, for most of us, there’s only so much money left over each month to put in the market. This means needing to pick and choose what we invest for, and how to make those investments. Fortunately, the UK offers two tax-efficient wrappers for investments through pensions and ISAs which can be a good starting point for most investment goals. Investors will often hold both, but what is the right split of cash between the two?

Even for those that are sitting on larger sums to invest, deciding if that money will be better used in a pension or ISA can be a complex decision. There are some basic questions to ask yourself that may give a more straightforward answer on whether to opt for a pension or ISA, but for those without immediate goals for their savings, and who are looking for tax efficiency, the answer can be more complex. Here’s a few things to consider about the two vehicles.

What’s the state of your pension?

If you work for an employer in the UK, make more than £10,000 a year and are 22 or older, you will be automatically enroled in a pension. Unless you’ve chosen to opt out of your pension contributions, that means that 5% of your gross salary is paid into your pension each year, and your employer pays in 3%. You receive a boost from the government on this contribution, because it isn’t taxed as income.

So, if you had a £35,000 salary, you’d be contributing £1,750 to your pension each year. If you chose to opt out of your pension contributions, you’d only get an extra £1,400 because the government would tax the extra income. Your employer would also be paying in £1,050 each year, which adds up to a total annual contribution of £2,800.

If you don’t currently make pension contributions, this could mean you’re missing out on a significant amount of cash, both through tax efficiency and your employer’s contributions.

For those that are making contributions under auto enrolment, the question of whether you are putting enough in to fund the lifestyle you are planning for retirement remains.

You can use AJ Bell’s pension calculator to get an idea of what your contributions will add up to over time. If you’re coming up short, an increase in contributions will be something to consider. Even if your pot is looking sizable, remember to think about inflation and how that could affect the cost of your targeted lifestyle by the time you reach retirement. In the past decade, CPI (consumer price index) inflation totalled an average of 3.3% per year, according to the Office for National Statistics.

Considering your current goals

If you’re trying to save for a goal that’s more imminent than retirement, such as buying a home, saving into a pension won’t be any help, because you won’t be able to access the money until you are at least 55, rising to 57 in April 2028. ISAs offer far more flexibility in this sense, because most of them do not have limitations on how or when they must be used. All the while sheltering the income you make from investments and any capital gains from HMRC.

ISA wrappers don’t provide income tax relief when it comes your salary or have the benefit of employer contributions, but it’s important to consider that only 25% of your pension will be free from tax upon withdrawal. This means the majority of your pension pot will be taxed at some point, it’s just further down the line.  

Lifetime ISAs are a popular choice for those saving for a first home and benefit from a government bonus. A Lifetime ISA must be used on the purchase of a first home, with a price of £450,000 or less. You can put £4,000 each year into a Lifetime ISA, and the government will top it up with 25% of your contribution, up to a maximum £1,000. Remember that Lifetime ISAs can only be accessed if you’re getting on the housing ladder for the first time or when you retire, other than in exceptional circumstances there are penalties for taking the money out early.

Even if you don’t have a specific goal now, you may want to consider if you’d like access to any of your investments before age 55. Each person can put £20,000 per year into their ISAs cumulatively, with some accounts having lower limits. This creates a substantial tax cover over time for your savings.

The benefits of pensions for higher income earners

For those that are climbing into higher earning brackets, there may be less of a stretch to fund different accounts, and more of a question of what method is the most tax efficient.

Pensions can play an extremely important role here because of their income tax relief. You can pay the lower of 100% of your salary or £60,000 into your pension each year and receive tax relief, if your salary is less than £260,000. If your salary exceeds this amount, the amount you can put into your pension while still receiving tax relief tapers, with a minimum of £10,000 for anyone earning £360,000 or more.

This can be a massive benefit for those who are additional or higher rate taxpayers and would otherwise be paying 40% to 45% of their salary towards income tax once they exceed the income thresholds. It can be particularly beneficial to those who are falling into the £100,000 tax trap.

This is the threshold where your personal allowance of £12,570 starts to diminish and benefits such as tax-free childcare and childcare hours for those with children are no longer available or limited.

Increasing pension contributions can put earners back under the £100,000 limit, allowing them to maintain these allowances.

For those that are on the brink of £100,000, paying a bit more into a pension could actually mean more cash for ISA contributions as well.

Let’s imagine a parent, Sue, who has just gotten a raise from £99,000 to £101,000. She would be taxed 40% on these extra £2,000 for a total of £800 and lose £500 from her personal allowance, resulting in another £2,000 loss to tax. That means already, £1,000 of her £101,000 raise is gone to tax.

If Sue has two children, she’ll also lose her £4,000 tax-free childcare and 30 weekly term-time hours of care for both children which is worth £22,880. This results in £27,880 of extra costs and tax from a £2,000 raise. By increasing salary contributions, Sue could knock her take home salary below £100,000, giving her access to these benefits again, and freeing that money up for an ISA investment instead.  

However, the most tax efficient way to invest may not always line up with your goals. It can be helpful in these cases to remember why you are investing in the first place, which for many of us, is having financial comfort and living the way we want to live.