Pension or ISA: What's best?​

We’ve all heard of a pension and most of us are told to save into one, but what do they actually mean? To put it simply, pensions are a special savings account so that you don’t spend all your money before retirement.

Pensions persuade you to tighten your purse strings now in return for tax relief on your money later. If that’s not enough, any money you make via interest or growth will be tax-free. What this means in real terms is whatever you save will be boosted based on your usual tax bracket. If you normally pay the basic rate of 20%, you’ll only need to save £80 in order to have £100 in total. For higher rate taxpayers this drops to £60 and additional rate taxpayers only need to pay £55. You can save your entire salary up to a maximum of £40,000 per tax year and still receive these bonuses. If you continually hit the max in search of the saving superhero title, be wary of the whopping £1.073m overall limit otherwise you might be taxed for any extra you put in.

Your pension pot has even more potential for savings thanks to something called the workplace pension scheme. Every employee since 2012 who’s aged over 22 and earns over £10,000 a year would’ve been auto-enrolled already. As well as benefiting from tax relief, you’ll receive at least a 3% bonus thanks to the minimum employer contribution. Don’t worry if you don’t meet this criteria as you can still ask to be enrolled as long as you’re an employee.

After you’ve saved a hefty chunk over your lifetime, now comes the fun part. Spending it. As with most things in life, there’s a catch. Since pensions are meant for retirement, you can only access yours when you turn 55 with this rising to 57 from 2028. However, as a little savings sweetener you can normally withdraw 25% of your total pot completely tax-free when you reach this age. Whether you choose to treat yourself or top up your annual takings is entirely up to you. Just be aware that any amount taken after this will be taxed depending on how much you take out per year.

Lifetime ISAs (or LISAs for short) were originally launched as an alternative to other individual pensions, something that you can read up on in our SIPP vs ISA rundown. As well as being a place to stash your savings away for retirement, they can also be used for reaching landmark life goals like buying your first home. They come in two forms - a standard Cash LISA or a Stocks & Shares LISA.

Both account types can be opened between the ages of 18 and 40 but unlike pensions, your annual savings limit is knocked from £40,000 to just £4,000. Despite receiving a 25% bonus up to the maximum of £1,000 a year, the government does stress that this should not be used in replacement of a traditional pension. As amazing as the government’s 25% bonus may sound, this will only be honoured for any withdrawals after the age of 60. Whatever you withdraw before this age will receive a 25% penalty and basically cancel out the top up you would’ve received.

If you were to start saving the maximum amount from 18 up to 50, you’d only end up with a total of £160,000 which, in most cases, wouldn’t last the length of your retirement if held in a Cash LISA. The Stocks & Shares LISA allows you to try and better your savings via growth in the stock market but there is no promise of this and you may actually lose money. As much as we’d love to be able to explain the stock market in a few sentences, we suggest reading our Top 5 Beginner Investment Funds to get a better idea of how Stocks & Shares actually work.

As this ISA is designed to dabble in the stock market, many see it as a place to put your pennies for the mid-to-long term. You won’t receive a bonus like a LISA but you can save up to a maximum of £20,000 a year in one of these accounts. Any money you make will be entirely tax-free and can be accessed whenever you like and without penalties.

Common advice says that you shouldn’t put any cash that you may need access to for the next 5 years. This, in theory, will help you ride out the highs and lows of the market and give you a better chance to make money. In a similar way to the Stocks & Shares LISA it’s important to reiterate that your money can go both ways. No matter how many financial advisors try to tell you different, it’s best to remember that even the so-called safest bets still carry some form of risk.

Benefitting from the same £20,000 tax-free saving limit as the Stocks & Shares ISA, Cash ISAs are mainly used to save money that you might need to dive into at short notice. Even if you won’t be throwing your money into stocks it can still be in danger of losing its value. In times of high inflation and low interest rates such as now, your money will actually buy you less than it can today. If your weekly shop costs 10% more in five years and your savings have risen by 2% in the same time, your money will have lost 8% of its original value. As you can see, this could have a massive effect over time and it’s why many people choose alternative places to store their retirement funds.