Pensions or ISAs - The pros and cons

Pensions typically dominate discourse around retirement planning, but ISAs are a great way to put money away for your future too. Knowing the pros and cons of each is vital to getting it right.

When most people think of retirement income, a pension is the first thing that comes to mind – and for good reason. With a number of different pension types to choose from, pension schemes are a highly tax-efficient way to save your hard-earned money during your working life, as well as grow it through investments and compound interest.

It’s not the only tax-free vehicle for saving and investing your money, however. Money put into Individual Savings Accounts (ISAs) is also able to grow, compound and enjoy income from investments completely tax free, yet ISAs tend to be more overlooked in retirement planning.

There are several reasons why pensions trump ISAs as a home for your retirement savings, but there are also areas in which ISAs trump pensions. In this article we explore each one’s pros and cons and how to choose which is the best option for you, including a combination of both.

The similarities between pension and ISAs

First it is useful to outline the similarities between pensions and ISAs. Both enable you to save and invest your money in a range of assets including stocks and shares. There are ways in which you can manage those investments yourself, or you can take advantage of funds and managers. You can control how much risk you are willing to take on to achieve greater returns.

With pensions and ISAs, your money can grow within that wrapper without you needing to pay any tax on capital gains or income received on investments. Elsewhere, however, their tax treatment, including tax-free allowances, can differ considerably.

Tax on contributions

One of the greatest advantages of a personal pension is the tax relief you receive on what you pay in. The amount paid in is uplifted by basic rate tax. In addition, the contribution can provide additional tax relief for high earners.  This second element does not add to the pension pot but makes the contribution particularly tax efficient. 

For example, if you put in £8,000, the government will top that up to £10,000. If you’re a higher-rate taxpayer you can claim back an extra £2,000 in your tax return, rising to £2,500 if you’re an additional-rate taxpayer.

It’s also worth noting that if you opt into a workplace pension, your employer will be paying at least 3% of your salary, which is even more free money going into your retirement pot. These advantages don’t exist when paying into an ISA. So, if you pay £8,000 into an ISA, that’s exactly what you get to invest.

Accessing your funds in a pension or an ISA

ISAs do not offer all the tax benefits available to pensions when paying into them, but when it comes to wanting to get money out, ISAs come into their own. That is because no matter how much your savings and investments have grown in your ISA wrapper, when you want money out there is no tax to pay.

On the contrary, beyond the first 25% which you are able to take tax free, any money withdrawn from your pension will be seen by the government as income and therefore you must pay income tax at the appropriate marginal rate. Remember, however, if you were a higher-rate or additional-rate taxpayer when you paid into your pension, and are a basic-rate taxpayer once retired, then you have benefited from a higher rate of tax relief than you now pay in income tax.

The other thing to consider is when you wish to access funds. This, again, is where an ISA might be seen as more beneficial, or at least more flexible, given there are no restrictions on when you can take money out. With pensions, your money is locked up until you reach an age set by the government, currently 55 but rising to 57 in April 2028 and likely to rise further in the future.

“This can make ISAs more attractive to younger people with shorter or medium-term savings goals, such as buying a home, or people who might wish to gift a sum to a child or a grandchild,” says Gill Philpott Tax and Trusts Specialist at Ascot Lloyd. “Anyone can provide funds to pay into a child’s Junior ISA (JISA) up to £9,000 per year or Lifetime ISA (LISA) up to £4,000 per year, with the government adding a 25% bonus, which is great if you want to help them save for their own home without affecting your own ISA allowance.”

In the Spring 2024 Budget, it was announced there would be a new ‘UK ISA’.  The new £5,000 allowance is in addition to the existing ISA allowance of £20,000, for people to invest in UK shares. Further information awaited on this allowance.

Inheritance tax*

If you expect to have a large estate when you pass away, and a portion of your retirement savings that you would like to leave behind to loved ones in the most tax-efficient way, then your pension will be more enticing as it isn't part of your taxable estate. ISA savings don’t enjoy the same exemption – while they can be inherited tax-free by a spouse or civil partner, left to anyone else they’ll be liable for 40% inheritance tax if the estate is worth more than the tax-free threshold (currently £325,000, or £500,000 if your children or grandchildren inherit your home).

Pension and ISA Limits and allowances

The final element to consider is how much can be saved into both a pension and an ISA without triggering a tax charge. The allowances vary considerably. With pensions, you can contribute at least £3,600 and up to £60,000 tax free each year depending upon your relevant earnings, unless you earn over £260,000 in which case every £2 of income over £260,000 reduces your allowance by £1. With ISAs, the annual allowance is only £20,000.

Currently, with a pension there is a lifetime allowance (LTA) of £1,073,100.   The lifetime allowance is being abolished from 6 April 2024 and will be replaced with the Lump Sum Allowance (LSA) with a standard allowance of £268,275 or higher for those with LTA protection which is the maximum tax-free lump sum that can be taken from a registered pension scheme during a member’s lifetime.  There is also a Lump Sum and Death Benefits Allowance (LSDBA) with a standard allowance of £1,073,100 or higher for these with LTA protection which is the limit of the combined amount of tax-free lump sums paid in the members lifetime and on their payments on their death.  This could create potential planning opportunities and you should discuss this with your financial adviser.

Difficult decisions

The differing rules surrounding ISAs and pensions can make it complicated to understand which is best for you, but it needn’t be an either-or decision. It’s important to see each as part of a holistic approach to financial planning, and the smartest approach might well be to utilise both.

If you’re reasonably sure you won’t need money until you retire, generally a pension is the best place for your savings,especially if you pay tax at higher rates. For savings beyond your pension allowance or for money you think you might need to access before your retirement, an ISA is the best alternative option. If you’ve used up all of your allowances and choose to put excess savings into a GIA (general investment account)  instead, you will also be able to move that money into an ISA in the future.  However, the reductions in both capital gains and dividend allowances mean there is more likely to be tax to pay on the income from a GIA and when you transfer assets in a ‘bed and ISA’ transaction later on.

“It's a difficult choice but think about what you are saving for, what's the goal with that money and then look at maximising the reliefs and allowances available, depending on your objectives,” says Philpott. “For retirement, a combination which maximises the reliefs and allowances of both could be your best bet. An Independent Financial Adviser will be able to assess your personal circumstances to understand how to best meet your financial goals.” 

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