Pensions vs ISAs

With life expectancy increasing, financial planning becomes all the more important. If you're thinking of saving for retirement, then you might consider a pension is the best way to ensure you have enough to live on when you're older. However, there are alternative ways of achieving your goals, such as using Individual Savings Account (ISA) allowances.

One of the main differences between a pension and an ISA is in the way they are taxed. Your pension payments will qualify for tax rebates up to your highest rate, while the income you take later on will be taxed. With an ISA, the money you contribute will have already been subject to tax, but then withdrawals you make are tax free. It's also useful to be aware that if you're over 65, your pension income counts towards your personal tax-free allowance, while your ISA withdrawals do not.

You might think, logically, that, thanks to the tax relief, a typical higher rate taxpayer saving a similar annual amount into both an ISA and a pension plan over their working life will find that by the time they reach retirement age the pension fund is larger. This is obviously fully dependent on their investment choices and tax regulations remaining consistent but it is important as it can influence the size of annuity that can be bought. However, that annuity income is likely to be taxable, unlike ISA withdrawals. But then withdrawing the same money from an ISA may eat into your capital quicker than planned, which could mean you eventually run out.

Other pension benefits include the fact that employers can pay into a company or stakeholder pension scheme, and the contribution limits for pension are much higher than for ISAs. Nevertheless, an ISA is much more flexible. With a pension, you have to wait until you are aged 50 to make withdrawals (which is expected to rise to 55 by 2010), whereas an ISA can be accessed quite easily.

With longer life expectancies, as well as some high profile issues concerning the way in which a minority of pension funds have been managed, many investors' retirement sums are not quite as large as expected. As a result, some people are now looking to boost their pension funds by topping up their company pension, or by using additional investment vehicles. One solution could be to use both an ISA and a pension plan to ensure that your retirement income is as healthy as possible.

Author Mark Taylor of IM Financial Solutions.