ISA or Pension?
The short answer is BOTH. ISA’s and pensions are taxed differently and therefore offer different ways to save for short, medium, and long term financial needs.
For most of us, Pensions and ISA's are all we need to build wealth. There is so much flexibility in these accounts that you are unlikely to need anything else. These accounts are simply ‘wrappers with tax benefits’ for saving and investing.
What is an ISA?
An ISA (Individual Savings Account) is simply a type of savings plan with tax benefits to help you save money primarily for the short, medium, and long term. All payments made into an ISA can be withdrawn at any time without any tax liability. Normal savings accounts and general investment accounts both attract tax. ISA’s can be wrapped around a bank savings account (i.e. cash ISA) or an investment account (i.e. Stocks and Shares ISA).
What is a LISA?
LISA (Lifetime ISA): A special ISA.
You can pay up to £4,000 into a LISA each year and the government will give you a 25% bonus i.e. £1,000!
FREE MONEY to Compound!
The LISA can only be used to buy a house or as a pension, otherwise, withdrawals have penalties. No brainer if you are buying a house!
For buying a house use a savings LISA - short-term saving, lower potential returns but less volatility. For pension saving use an Investment LISA - longer-term saving, higher potential returns but greater volatility (We’ll cover investing soon!).
What is a Pension?
A Pension (Company or Personal Pension Scheme) is simply a type of savings plan with tax benefits to help you save money primarily for retirement, currently after the age of 57. All payments into pensions are tax-free i.e. the government will give you a 25% bonus. For example, if you pay £100 into your pension the government returns £25 tax into your pension.
FREE MONEY to Compound!
If your employer has a Company Pension Scheme they will usually make a contribution matching what you pay e.g. if you pay £100 a month, your employer gives you £100 as well. This is in addition to your agreed salary!
More FREE MONEY to Compound!
Make sure you max this out! If your employer does not provide a company pension scheme, you will have to find a platform like Vanguard to provide a Personal Pension.
There is also a more specialised type of Company Pension Scheme called Defined Benefit which guarantees to pay an income at retirement rather than a pot of saved cash. Defined Benefit schemes are in decline and tend to be provided mainly by the public sector like the NHS and civil service.
(NOTE: the above pension schemes are separate from The State Pension which is provided to everybody by the government, the amount of which is dependent on the number of years’ national insurance tax you have paid).
You can pay up to £40,000 per year into a pension, capped at how much you earn, or £3,600 if you do not earn anything.
You can hold both an ISA and a LISA at the same time and the maximum that you can pay into both is £20,000 per year.
What is the tax benefit?
Starting early and saving regularly is the most effective way of bringing the pot at the end of the rainbow within reach. Both pension and ISA wrappers encourage you to save by offering generous tax relief, but this comes at different times and with different trade-offs.
A pension allows you to make payments before tax – in other words, you do not pay tax that would otherwise be due on the bit of income you have put aside. For a basic rate taxpayer that is 20% and if you are a higher earner, you can claim a further 20% or 25% back through your tax return.
By contrast, payments into an ISA attract no tax relief. The ISA comes into its own when you want to spend your savings. All payments from an ISA are tax-free.
Withdrawals from pensions cannot be taken until age 55 and are taxed as income, although up to 25% can be withdrawn tax-free. An ISA can be cashed in tax free at any age, therefore an ISA can provide a tax-efficient home for savings when you are young or your income is unpredictable and you need reassurance that the money will be available at short notice if needed.
The Lifetime ISA (LISA) is a special offer not to be missed.
The LISA lets you save up to £4,000 every tax year towards a first home or your retirement, with the state adding a 25% bonus on top of what you save. That means you could get a chunky £1,000 of free cash annually. Plus, you earn interest on whatever you save, and as it's an ISA, that interest is tax-free.
You can withdraw money at any time to buy a house without any penalties. You can withdraw money at any time after the age of 60 without any penalties and free of income tax unlike a pension, but if you withdraw before the age of 60, not for a house purchase, there is a 25% charge.
There we go, that’s the basic details behind these three simple accounts; make sure you make the most of the free money that can be yours through a pension and LISA!