The Tax Benefits of Pensions

There is one big difference between an ISA and a pension when it comes to tax, and this lies in the timing of when the tax is taken. Money that goes into an ISA has already been taxed. This means that any income generated or indeed capital gains made when you sell, are not taxed. All taxes are in effect tax free.

On the other hand with a pension, the government gives you your tax benefits up front, but what exactly does this mean to you?

It means that if you are a basic-rate taxpayer, when you pay £80 into a pension, the taxman grosses it back up to £100. (In other words, you get back the 20% tax you paid on that £100 when you earned it).

If you're a 40%-rate taxpayer things are even better, since you only have to pay £60 to make a £100 pension contribution. You automatically get the £20 basic rate tax back from the taxman immediately, and you can then claim back the extra £20 on your yearly tax self-assessment form.

You should be aware that there are limits on this tax relief. Currently, the annual limit is £50,000 a year, with a lifetime limit of £1.5m. For most people this means that you can put as much money away as you like, within reason.

The downside to a pension is that income generated by a pension is taxable when you take it in retirement. When you first access your pension, you are allowed to take a 25% lump sum tax free. The rest must be used to provide a retirement income.

For the majority of people, this income will be in the form of an annuity (an income stream that you purchase with your pension pot), although there are other options such as income drawdown.

The important point to remember is that income from an annuity or anything else you do with a pension, is liable for income tax.

In Summary

If you look at the numbers, for basic rate taxpayers, there isn't a huge difference between pensions and ISAs. The tax-free lump sum is the main advantage enjoyed by the pension.

For higher-rate taxpayers, pensions win out. This is because the tax relief is particularly generous.

It's even better if you end up in a lower-rate tax band once you're retired (which is more than likely for all but the richest pensioners), since you will get higher-rate tax relief paying in, then only pay lower-rate tax from the resultant income.