‘So many people get wrong’ – Why pensions are ‘much better value’ than ISAs

Martin Lewis advises on opening a Lifetime ISA

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Both pensions and ISAs offer different benefits which may make them suitable options for different people. However, an expert has shed light on some mistakes that “so many people get wrong” when comparing the two. On the Meaningful Money Youtube channel, financial planner Pete Matthew discussed the pros and cons of both options and explained what he believes is better for retirement savings.

He explained that on the surface ISAs can seem like the better option due to the tax relief it provides.

ISAs are offered by banks, building societies and other providers by which people can save up to £20,000 each year tax free.

In comparison the Government also gives Britons a bonus when they pay into their pensions tax free.

When a person earns tax relief on their pension, some of the money that would have been paid in tax on the earnings goes into the pension pot rather than to the Government.

The tax relief is paid on pension contributions at the highest rate of income tax people pay. So basic-rate taxpayers get 20 percent pension tax relief and higher-rate taxpayers can claim 40 percent pension tax relief.

However, on withdrawal, over a certain amount, Britons will end up paying tax on their pensions.

People can usually take up to 25 percent of the amount built up in any pension as a tax-free lump sum.

The tax-free lump sum doesn’t affect their Personal Allowance, but tax is taken off the remaining amount before people can receive it.

Mr Matthew agreed that on the surface ISAs seem better as there is no tax on withdrawal, but he believes “pensions always work out better value,” even taking the tax on withdrawal into account.

He said: “Only in the very unlikely situation that someone is a basic rate taxpayer the whole time they are saving into a pension, and then a higher rate taxpayer when they retire can we get the ISA to look like a better option.”

He gave an example to illustrate his opinion.

If a 25-year-old started saving £250 a month into a pension or an ISA until aged £65, with six percent growth there would be significant differences.

The pension is growth stock, using basic rate tax relief of 20 percent, the amount being saved doesn’t change. The pension eventually being withdrawn from has been crystallised and they take zero tax free cash.

At 65, the ISA would have £492,143.05, and the pension would have £590.571.66.

If they started withdrawing £750 a month (after tax), from 65 to 80, the ISA pot would be worth £1,005,300, and the pension would be worth £1,194,114.

Mr Matthew continued: “When they get to 100, the ISA is worth £2,873,200 and the pension is worth £3,391,019. So, they’d be £500,000 better off in a pension. But it’s better than that.

“If they die at age 100, their ISA pot will be subject to inheritance tax. The value of the pot could be reduced by 40 percent significantly, taking it down to £1,723,920, causing a family to pay over £1million in inheritance tax.”

Despite being taxed on the back end with pensions, the growth and compounding on the tax relief is so valuable, he explained.

He said: “It doesn’t take much to reach this critical mass so you can’t undo the benefits of that growth.

“When you add in the flexibility of pensions and the insanely beneficial treatment on death even after age 75 it’s hard to argue that ISAs are best.”

However, he explained that there are benefits to having both and people should do their own research to decide how they can use both in their portfolios.

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