Should I pay into a Stocks and Shares ISA or a Pension?
Two common investment products that can often confuse us when deciding which one is best for our money: our Stocks and Shares ISA or our Pension.
If you have money you’d like to invest, is one option better than the other?
First, the key similarities between a Stocks and Shares ISA and a Pension
1) Both products are tax efficient i.e. reduce the tax you pay
2) Both products can produce tax-free growth while invested
3) Both products do not guarantee returns. You could lose money
4) Both products offer some form of protection should the provider fail
Now, the key differences
Assuming you’re a taxpayer, a Stocks and Shares ISA is taxed ‘on the way in’ – this means you’re funding it from net income that has already been taxed.
A Pension is taxed ‘on the way out’ – treated as income, you may have to pay income tax when you withdraw from your pension.
Access to your money
Funds in your Stocks and Shares ISA can be accessed at any time.
Funds in your Pension can only be accessed from age 55 (57 in from 2028).
You can contribute up to £20,000 per tax year into a Stocks and Shares ISA (this allowance runs across the 3 other ISAs too; Cash ISA, Lifetime ISA (max £4,000) and Innovative Finance ISA). This allowance is lost at the end of each tax year if you don’t use it/all of it.
You can contribute up to £40,000 or the value of your annual earnings, whichever is the lowest, per tax year into your Pension. Those earning over £240,000 may find their £40,000 allowance reduced. This allowance is carried over for up to three tax years if you don’t use it/all of it.
Tax on death
A Stocks and Shares ISA will form part of your estate and could, therefore, be subject to inheritance tax if the total value of your estate is worth more than the Nil Rate Band of £325,000.
A Pension remains outside the estate as long the money has not been withdrawn to your bank account. This means no inheritance tax is due on a Pension.
Passing it on
You can leave a Stocks and Shares ISA to anybody you like, provided you specify this in your Will. A spouse or civil partner gains an allowance equal to the value of the ISA at the time of death, to be used within three years. This is on top of the surviving partner's annual £20,000 allowance.
To pass on a Pension, you must nominate a beneficiary. If you die before 75 years old, your beneficiary will get your pension tax-free. If you die after 75, your beneficiary will pay income tax on it.
So, should I pay into my Stocks and Shares ISA or my Pension?
Unfortunately, an article like this can never give you a definitive answer. But we can look through some of the factors I’ve mentioned and apply them to your personal circumstances.
When do you need to access the money?
Firstly, if its less than 5 years, then a Stocks and Shares ISA is not recommended as it exposes you to greater risk of loss during a market downturn, with not enough time to recoup the losses.
If you’re a long time away from being able to access your Pension at 57, are you comfortable locking money away for that period?
Establishing your timeframe will help you decide what’s best for your money.
What sort of Pension are you paying in to?
Certain types of pensions may offer greater financial benefits than others.
If you have a workplace pension, your employer may match any increase in payments that you want to make. This is free money and is great financial planning. If you’ve not done so already, check the maximum employer-matched contribution you can make. If you’re not maxing it out already, it makes sense to do so if you can afford it.
Even if you have maxed out employer-matched contribution, check what type of scheme your employer is using.
There are three kinds of workplace pension scheme:
1) Relief at Source – your employer pays into your pension after tax and national insurance have been deducted from your gross salary. The government then top up the payment with 20% of its value. If you’re a higher rate or additional rate taxpayer, you then claim the extra 20% or 25% through self-assessment tax return.
2) Net Pay – Your employer pays into your pension from your gross salary – so the tax relief is instant, and nothing needs to be added by the government or reclaimed by you. National Insurance contributions are still deducted from gross salary.
3) Salary Sacrifice – you give up part of your salary to go directly into your pension. This is the most tax efficient way of paying into a pension as it reduces your National Insurance contributions too. Pound for pound, it can’t be beaten.
If I didn’t need access to the money until retirement and was in a Salary Sacrifice scheme, I’d most likely pay into my Pension instead of a Stocks and Shares ISA.
What will your tax status be when you want the money?
As explained, there is no tax to pay on withdrawals from a Stocks and Shares ISA. But you’ll most likely have paid into it from ‘net funds’ so tax has already been taken at some point prior to investing.
With a pension, the rule is that you get 25% of it tax-free and the rest is taxed at your rate of income tax. However, if you’re not a taxpayer when you come to withdraw the money, you may not pay any tax at all on your pension withdrawal , making it a better option than an ISA.
You pay £1000 into your Stocks and Shares ISA. Assuming you’re a basic rate taxpayer, that was £1250 originally (20% of £1250 is £250, subtract that giving you £1000 in your pocket).
You pay £1000 into your Pension. Assuming you’re a basic rate taxpayer, this is boosted to 20% as you get the tax back as a benefit of contributing into your Pension. So, you actually pay in £1250.
Let’s assume your Stocks and Shares ISA has tax-free growth of 20% when you want to withdraw the money. It’s now worth £1200. There is no tax to pay. Your net withdrawal is £1200.
Now let’s assume your Pension also has tax-free growth of 20%. It’s now worth £1500. You can take the first 25% tax free, which is £375. That leaves £1125 which is taxed at 20%, giving you £900 net. This gives a total net pension payment of £1275.
So already, paying the same amount into your Pension vs ISA has left you £75 better off in your Pension.
This could be even better if you’re a non-taxpayer when you withdraw the money.
Remember – pension payments are subject to income tax so you can use your annual personal allowance (currently £12,570) to avoid income tax if you earn under that amount.
To the contrary, if you’re a non-taxpayer, don’t have a workplace pension/have maxed out your employer-matched contributions and want to pay into a Stocks and Shares ISA or Pension, the ISA may be the better option as in this case, there would be no tax on the way in or on the way out.
Is your estate worth over £325,000?
If you have a large estate, then building up a bigger pension pot can help reduce inheritance tax liability. Your Nil Rate Band – the amount your estate can be worth before you need to pay inheritance tax – is £325,000 plus up to £175,000 if you own your home. It may be up to £1,000,000 if your spouse or civil partner passed away with unused nil rate band. You can find out more about inheritance tax rules on the government website here.
Think about your life expectancy
The aged 75 rule for pension inheritance may be, and sorry to be morbid, useful if you believe you have low life expectancy. Many people like the fact that a tax-free pension sum can be passed on to their beneficiary if they die before they turn 75.
There are many things to consider when deciding whether to pay into your Stocks and Shares ISA or your Pension. Having the option of either is a great place to be in.
ISAs offer more flexibility in terms of access. Pensions offer greater tax efficiency if you’re a taxpayer. Both are not without risk.
If you’re considering paying in a large sum, seek professional support from a qualified financial adviser like myself.