If you’re blazing along the path to financial independence and hellbent on retiring young, should you invest in a Pension or ISA?
Traditional retirement advice – which promotes saving around 10% of your salary into a pension–won’t allow you to retire in your 30’s or 40’s.
And with pension contributions locked away until you’re 55, it raises the question:
Are pensions useless if you’re pursuing FIRE (Financial Independence Retire Early)?
Should you invest in ISAs or property instead?
In today’s post, we’re going to consider the various investment vehicles and decide if there’s one that trumps all when it comes to achieving financial freedom early in life.
Becoming An Income Investor
To become financially independent, you need to find a means of replacing your employment income with passive income.
You have to acquire assets that yield a consistent cash flow that rolls in month after month just as it did when you held down the 9-5.
That means you must become an income investor. As I’ve written about before, there are only three “true” investments that produce a reliable and consistent passive income that FIRE investors should hold in their portfolio; shares, property and bonds.
The mammoth task you’ve got is building a portfolio of these three cash-flowing assets to replace your job income but also doing it in the most tax advantageous way possible.
The UK government provides you with two tax-efficient means of holding your investments: pensions and ISAs.
These two methods of owning assets – often referred to as tax wrappers as they wrap around your investments shielding them from tax – should be used to maximum benefit.
Everyone should pay their fair share of tax, but there’s no point in being overly generous to the tax man.
Understanding Tax Wrappers
Pensions and ISAs are unique in the way that they tax contributions and withdrawals, and their rules on accessing your investments are vastly different.
Let’s take a closer look at the key differences between the two tax wrappers – pay attention here; being clued up on tax will help you reach early retirement sooner and ensure your retirement income is maximised.
If you earn over £10,000, you’ll be automatically enrolled into your workplace pension, and you’ll have to contribute 5% of your gross salary to it.
At age 55, you can access your pension – either in one lump sum (with 25% of it being tax-free), or by drawing from it gradually over time, or a mixture of the two.
With pensions, you receive tax relief on the way in, but you get taxed on the way out.
In other words, pension contributions are taken from your gross salary before you pay tax.
If you’re a basic rate taxpayer paying 20% tax, a £100 contribution to your pension would actually only cost you £80.
The government tops up your pension donation by £20 (by not taxing you) as an incentive to save for your retirement.
And if you’re a higher rate (40%) or additional rate (45%) taxpayer, the reward is even greater!
You’ll be able to purchase £100 worth of assets in your pension for £60 or £55 respectively – effectively a 40-45% discount!
This is hugely beneficial, as you’ll be able to buy more investments with pre-tax income, which will then benefit from years of growth without being taxed while they’re held in your pension.
Better still, your employer legally has to contribute 3% of your gross salary into your pension on top of your 5% donation.
Some companies even offer higher contribution matching above the 3% legal requirement.
For example: if you save 8% into your pension, your employer will also contribute 8%.
If your lucky enough to work for a company that offers to match higher pension contributions, take it!
In my opinion, contributing to a personal or workplace pension is the best way for the majority of people to fund their retirement.
With deductions automatically taken from your wage, your employer topping up your contributions and pension access restricted until you’re 55, you’re effectively “forced” to save for retirement.
There’s no willpower required. You’ll build a sizeable nest egg over you’re working life, and combined with your state pension you’ll receive at age 65, you’re set for a comfortable retirement.
However, if you’re planning on retiring early, a pension’s benefits become its hindrances. Locking your savings away until you’re 55 is a big drawback if you plan to retire in your 30’s.
And the age that you can withdraw a private pension is set to increase to 57 in 2028 and is likely to keep on rising!
ISA (Individual Savings Account)
With ISAs, you don’t get tax relief on the way in, but you’re not taxed on the way out.
Simply put, that means contributions to an ISA are made with your after-tax earnings, but they’re shielded from tax while they’re held in an ISA.
Any income you regularly withdraw from an ISA, such as dividend income, isn’t taxed.
You also don’t pay tax on any assets held in an ISA that have appreciated that you decide to sell.
There are several types of ISA that you can invest in which allow you to diversify your savings across several asset classes.
The most common are cash ISAs and stocks and share ISAs, but you can also invest in P2P lending or commercial property (via property funds listed on the stock market).
Unlike pensions, you can access the capital or draw an income from an ISA at any age, which is clearly more advantageous to those pursuing FIRE.
But ISAs do have some downsides; mainly the lack of employer matching (which plays a big part in boosting pension returns) and there being a maximum limit you can invest into your ISA each tax year (currently £20,000).
Investing Outside A Tax Wrapper
In most instances, it makes sense to invest in your pension or ISA before investing elsewhere.
For example, if you bought shares in a general investment account before maxing out your ISA allowance for that year, then you would unnecessarily be paying tax on any capital appreciation or income received.
But this isn’t always the case.
Residential property, for example, can’t be invested in directly via a pension or an ISA.
Investing in bricks and mortar must be done with after-tax income. However, the returns you can achieve from buy-to-let investing can far exceed those from stocks or funds held in your pension or ISA.
This is primarily due to the power of leverage (buying property with a mortgage), which can’t be utilised within either tax wrapper.
Your Age Matters
Your current age and the age that you desire to leave the working world behind plays a big part in deciding whether an ISA or pension is the better vehicle for you.
If you’re nearing 55, then it may make sense to max out your pension contributions.
Especially as you’re likely to be at a point in your career where your earning potential is at its peak, and your contributions are going to be significant.
Plus, paying in more to a pension may help you avoid being pushed into a higher tax bracket.
On the other hand, if you’re in your 20’s and pursuing FIRE, ISAs should be given greater precedence over a pension.
Prioritise maxing out your ISA with assets that pay you, such as UK equity income funds, bond funds or REITs (Real Estate Investment Trusts). And then when you’re ready to hand in your notice, you’ll have a relatively stable income from your ISA that you don’t have to pay income tax on.
I would also give serious consideration to investing in buy-to-let (BTL) property.
Even with the recent tax changes making BTL less profitable than it once was, it’s still one of the quickest methods of becoming financially independent.
Being able to negotiate a discount, increase the property’s value with renovations, and using a mortgage to leverage your investment, gives property a leg up on other investments.
A return on investment of 15% is easily achievable with a typical BTL, and returns of 30% or more are possible if you’re willing to put in the work.
But what about pensions if you’re a young investor? Should you stop contributions and just focus on ISAs and property?
Never opt out of your workplace pension scheme unless you’re facing extreme financial hardship.
Always contribute the minimum 5% so that you get the employer 3% match.
Employer contributions to your pension are effectively FREE MONEY!
And when someone offers you free money, don’t be coy. Stick out your hand and gratefully accept it.
Plus, you never know what the future holds – keep your realist hat on and don’t expect life to be plain sailing. Sickness, injury, lay-offs or any number of financial dramas could stick the breaks on your early retirement plan.
If you’ve been contributing to your pension you’re entire working life, you’ve going to be financially secure in your golden years.
The Final Word
So, if you’re goal is to retire early, is it better to invest in a pension or an ISA?
Well, there isn’t a clear-cut answer – it depends on your age, your desired retirement age, income, drawdown options, tax bracket, and a host of other factors.
I’m biased towards ISAs and property investing because I’m 32.
55 still feels like a lifetime away, and I base my decisions on maximising my cashflow now. But stating the bleeding obvious, everyone’s situation is different.
Having knowledge of how the tax wrappers operate and the rules over access and taxation will help you to devise your own investment strategy for early retirement.
Utilising both tax wrappers effectively will get you to early retirement sooner – even if your pension is just a backup in case it all goes tits up.