Pensions vs ISAs

Just because you've got to save for your retirement, it doesn't mean that you should automatically get a pension. There's more than one way to skin a cat and ISAs provide a useful alternative. That said, many people these days tend to save using both ISAs and pensions, and sometimes other methods too.

The big difference between pensions and ISAs is when you get your tax benefit. With a pension, you make contributions out of your pre-tax earnings, but get taxed on the income when you draw your pension. With an ISA, you contribute out of your post-tax earnings, but get tax benefits on any income that you take from it.

All things being equal, this amounts to the same thing. For example, look at the position for a higher rate taxpayer who saves £1,000 gross (that is, £600 after tax), saves it and gets 9% growth for three years before drawing income at a rate of 5%. Each year's income will be the same, for the ISA and the pension:

• ISA: 60% x £1,000 x 1.09 x 1.09 x 1.09 x 0.05 = £38.90
  
• Pension: £1,000 x 1.09 x 1.09 x 1.09 x 0.05 x 60% = £38.90

As ever though, this position is confused by a number of factors. First of all, you're able to take part of your pension pot (usually up to 25%) as a tax-free lump sum.

Secondly, the above example assumes that you will pay the same rate of tax in retirement as you do during your working life. Most people's retirement income is lower than their salaries, which may mean they are taxed at a lower rate. For example, someone currently earning around £50,000 a year could get 40% tax relief on their pension contributions but only pay basic rate tax of 20% once they've retired.

So, if you are a higher rate taxpayer now but expect to be a basic rate taxpayer in retirement and/or you intend to take the maximum tax-free lump sum, the pension route has a slight tax advantage.

Other benefits of saving via a pension are:

• if you lose your job, you'd have to use up most of your non-pension savings before you qualified for any welfare benefits;
  
• any pension that you have will be protected if you are made bankrupt;
  
• if you have a company or stakeholder pension scheme, your employer may pay into your pension too; and
  
• contribution limits for pensions are much higher than for ISAs.

Traditionally, the biggest problem with pensions used to be their high charging structure. Generally, financial service companies don't miss an opportunity to muddy the waters on charges and this means that, traditionally at least, the charges on pensions have been a good deal higher than those on a cheap, transparent ISA. That's less the case these days, as pension charges are now much lower than they used to be.

So, arguably the main problem with the pension route now is its inflexibility. Once money has gone in, it can't come out until you reach 55 years of age and then it's taxed. Once you have started drawing your pension, you can't pass your pension fund onto your heirs (although there are plans to make this possible in some circumstances). However, had you saved in ISAs, whatever remained upon your death could be passed on. Of course, this has its drawbacks too. If you spend your money too quickly, your ISA retirement fund could expire before you do!

All in all, there are as many different arguments about the pros and cons of pensions over ISAs as there are different types of pensions and ISAs. The important thing to take on board is that the decision, either way, is generally not clear-cut. If someone tries to tell you that a pension is unambiguously a good idea, then there is a fair chance that they have an expensive pension to sell you!

Whichever way you choose to go, don't forget the normal principles of Foolishness. Remember to avoid high charges as, over the long term, these will have a very significant and negative impact on your investment performance. Remember also that when you are saving for the long term, the returns from shares are almost invariably superior to the returns from other types of investment.