Should I put extra cash in my pension or open a stocks and shares Isa?

I’ve always been in lower paid jobs and will be until I retire.

I’m currently in my mid-40s and just this week started my pension on the company salary sacrifice scheme, putting in 7 per cent while the company puts in 4 per cent of my pay.

However, I can add a little more and I have two questions. First, is there anything I can do after I have paid in my 35 years for a state pension?

It seems unreasonable that I will barely have enough in my pension for myself yet I will be paying for someone else for nearly 20 years of backbreaking labour in a steelworks.

Second, would it make more sense to add more to my workplace pension or start a stocks and shares Isa?

I get paid weekly so I’m reluctant to pay fees to fund the Isa as payments will be weekly and regular.

SCROLL DOWN TO FIND OUT HOW TO ASK STEVE YOUR PENSION QUESTION     

Steve Webb replies: It is good to hear that you are making meaningful contributions into a workplace pension in your mid 40s.

You are more than two decades away from being able to retire on a state pension so if you can keep this contribution rate going (and perhaps increase it, as I discuss below) you should get a worthwhile pension pot.

The foundation of your retirement income will be your state pension.

For someone of your age, 35 years of full rate contributions should generate a full flat rate state pension, currently £179.60 per week.

You make the fair point that if you go on working and contributing beyond that point then your pension would not increase any further and your additional contributions would simply go into the Government’s coffers.

On the other hand, the advantage of the 35-year rule is that if you did have to stop work prematurely because of ill health, you might already have built up a full pension and would not lose out.

The state pension system has always had an element of ‘redistribution’ in it, so that higher earners tend to subsidise lower earners and those with long working lives subsidise those who – often through no fault of their own – are less able to build up a full contribution record.

This includes those who are credited with contributions for things like bringing up a young family or caring for a disabled person.

In terms of potential use for a bit of extra cash, it’s good that you are thinking about investing for growth, which makes sense given you are many years away from retirement.

There are several potential upsides to opting for the workplace pension over a stocks and shares Isa.

The first is that some employers will put a bit extra in if a worker opts to pay in extra above the standard amount.

This will differ from firm to firm, but if your employer offers, for example, to match any extra pension savings you do up to a limit then this is a hugely cost-effective way to build your savings.

In any case, if your employer will let you make additional contributions through the ‘salary sacrifice’ route this will reduce the cost of additional saving into a pension compared with an Isa.

The second advantage of the workplace pension option is the tax treatment of pensions compared to Isas.

Both have tax advantages. A pension gives you tax relief on your contributions but charges tax when you take your pension. With an Isa you contribute out of your post-tax pay but no further tax is payable on the returns on your investments.

But the big advantage of the pension over the Isa is the tax-free lump sum you build up.

In general, a quarter of your pension pot can be taken as a tax free lump sum and for someone of your age you are likely to be able to access this at 57 or 58.

A third potential advantage of the pension is lower charges. If you are in a standard workplace pension used for automatic enrolment then the charges on the ‘default’ investment fund is capped at 0.75 per cent and could be lower.

Isa charges can vary considerably depending on the specific product, but you may end up paying higher charges with an Isa.

Having said all of this, the one big advantage of an Isa is that you can get at your money straight away, whereas with a pension it is locked up until your late 50s.

If you already have separate money set aside for ‘rainy days’ or emergencies, then you may be happy to lock up your additional savings in a pension.

But it is important not to leave yourself so stretched for short-term savings that if you had an unexpected cost to meet you would have to turn to potentially high cost credit rather than use your rainy day savings.

One final thought is the need to plan ahead not just in terms of your finances but also your career.

There is much talk these days of ‘mid-life MOTs’ where you can review your financial and career plans.

You mention that your work is physically demanding and perhaps this means you may not be able to do your current job up to pension age.

Benefits for those under pension age are very modest, so you may struggle to make ends meet if you are forced to retire early.

So it would be worth thinking now if there are other things that you might be able to do for paid work later in life and perhaps think about the skills and qualifications you could be developing now to prepare for that transition.