Pensions and ISAs are both ways of investing for the future which have significant tax benefits.
The best choice for you may depend on your financial goals. The money you pay into a pension is boosted by tax relief, but it is also locked away until you turn 55 (57 from 2028). In contrast, you can withdraw money from most ISAs tax-free at any time.
Given that they offer contrasting tax benefits, there is no reason why you can’t make the most of both.
What is a pension?
A pension is a way of investing for your retirement. Every £80 you pay into a pension is topped up by tax relief to £100. If you are a higher or additional rate taxpayer, you can claim back even more.
This money is invested over time to leave you with a pot of money which you can access when you are 55 (57 from 2028). The income you take from your pension in retirement is subject to tax.
Many different types of pensions are available. Most people use their workplace pension and benefit from their employer contributing as well.
Another option is a personal pension such as a Self-Invested Personal Pension, or SIPP, which allows you to choose and manage your own investments.
There are also defined benefit, or final salary, pensions available through some workplaces, but these pensions are much less common than they used to be.
What is an ISA?
ISAs, or Individual Savings Accounts, are tax-efficient savings and investment accounts. The key advantage of most ISAs is that you won’t pay any tax on your gains or withdrawals.
There are three main types of ISA:
- Cash ISAs – tax-free savings accounts.
- Stocks and Shares ISAs – investment accounts in which your gains are tax-free.
- Lifetime ISAs – cash or investment accounts which have a 25% government bonus on contributions up to £4,000 per year. However, you can only use the money to buy your first home or once you turn 60.
You can contribute up to £20,000 to your ISAs each tax year.
Pensions and ISAs compared
Both pensions and ISAs are free from Capital Gains Tax and tax on UK dividends.
The main difference is when you can access your money and how your money is taxed on the way in and the way out. Pensions have the advantage of tax relief, so you don’t pay tax on the money you put into a pension, whereas ISA contributions are paid in after tax. But with pensions, you pay tax on what you take out when you retire.
Tax benefits on contributions
The key advantage of a pension is tax relief, which is essentially a government top-up on your contributions.
Pension tax relief is based on your income tax rate. So if you are a basic rate taxpayer, you’ll get 20% tax relief. In practice, this means that every £80 you contribute is topped up to £100.
If you are a higher or additional-rate taxpayer, you get 40% or 45% tax relief. The first 20% is added to your pension automatically, and you can claim the rest on a self-assessment tax return.
This boost to your savings is paid on the way in, which means there is more time for that money to benefit from potential investment growth and compounding. Over time, this should mean your money grows faster than if you had the same investments in a Stocks and Shares ISA.
You will not receive tax relief on contributions to an ISA.
Accessing your money
While pensions have more generous tax benefits on contributions, ISAs have the advantage in providing tax-free access to your money. Unless it is a Lifetime ISA or a fixed-term Cash ISA, you can access your ISA savings tax-free at any time.
You cannot access the money in your pension until you turn 55 (57 from 2028). You can take up to 25% of your pension as a tax-free lump sum, but the rest is subject to Income Tax when you withdraw it. However, many people need a lower income and pay less tax in retirement than when they are working.
Each tax year, you have an annual allowance of up to £20,000 for ISA contributions.
The amount you can add to your pension depends on your earnings. You can pay in up to 100% of your earnings up to a maximum annual allowance of £40,000. Contributions made by your employer are not limited by your earnings, but do count towards your allowance.
If you are not earning, you can still add up to £3,600 to your pensions each year.
However, there is a reduced annual allowance for anyone earning over £240,000 a year. Your allowance is also reduced to £4,000 if you have taken a taxable income from your pension.
Stocks and Shares ISAs offer the flexibility to pick from a wide range of investment options.
If you have a SIPP, you can choose from a range of investments like you can in a Stocks and Shares ISA. Many workplace pensions don’t offer such a wide range of options and may limit you to a few default funds.
You should also remember that investing comes with the risk of losing money.
Inheritance and benefits after death
Your spouse or civil partner can inherit your ISA tax-free. However, your ISA will form part of your estate if you pass it on to anyone else. The first £325,000 of your estate is tax-free but anything above that threshold is charged 40% Inheritance Tax.
Pensions are not subject to Inheritance Tax. If you die before you are 75, you can pass on your pension to your beneficiaries tax-free. If you die after the age of 75, your beneficiaries pay Income Tax at their marginal rate on the money they inherit.
Defined benefit, or final salary, pensions can have different rules depending on the individual scheme.
Pension vs ISA: which is best for me?
If you are choosing between a pension or an ISA, you should consider what you are saving for. If you are saving for your retirement, then a pension is probably the better option due to tax relief. If you may need your money sooner, ISAs are far more flexible.
Of course, it is not an either-or decision. You could invest in a pension to save for retirement and in an ISA for savings which you can access when you need to.
Why choose an ISA?
As an ISA allows you instant, tax-free access your money, it is more suitable if you might need your money before you retire. You could use an ISA to save for a new house, car or just for a rainy day.
Although there is no tax relief, ISAs still have several tax benefits. Your money is sheltered from Income Tax, Capital Gains Tax and UK dividends are tax-free.
Why choose a pension?
It is usually better to choose a pension to save for your retirement.
Every £80 you pay in will be topped up to £100 by tax relief. Over many years, this should provide a big return on your savings and help you to grow your retirement funds.
While your pension income is taxed, you can take 25% tax-free and there is currently a £12,500 personal allowance for tax-free income every year.
How to decide which is better for you
Pension or ISA? You don’t have to pick one or the other. You can invest in both.
However, here are a few things to consider if you are deciding which one to prioritise:
What are you saving for?
This is perhaps the key question you should ask yourself.
If you think you might need your money in the short term, then an ISA is the better option. Most ISAs provide the flexibility to access your money when you need to without paying tax.
When will you need the money?
If you need the money before you retire, then an ISA is clearly more suitable.
However, as a rule of thumb you should only aim to contribute money to a Stocks and Shares ISA if you plan to leave it invested for at least the next five years. This should be enough time to help you to ride out any dips in the stock market.
How much money will you need when you retire?
You should think about how much money you would like to have each year when you retire.
You might have the state pension to fall back on in retirement as well as your personal pension. However, the full state pension is currently under £9,500 per year, and you cannot take that money until you are 67 (and the age limit is set to rise in the future). This means you’ll probably need extra savings to rely on once you’ve stopped working.
Use our pension calculator to help get an idea of how much your current level of contributions will leave you with when you retire.
Have you started saving into a pension?
The sooner you start saving in a pension the better. If you are in your twenties or thirties, getting your hands on the money in your pension can seem like a distant prospect. But by starting early, you allow more time to benefit from tax relief and potential growth on your investments.
Can you benefit from employer contributions?
If you are in a workplace pension scheme, your employer is required to pay the equivalent of at least 3% of your salary to your pension. For someone earning £27,000, that means at least £810 extra in your pension each year.
How is your money invested?
You should consider how your investments are performing if you are deciding between a pension or a Stocks and Shares ISA. While a SIPP allows you to choose your own investments, some pensions do not.
It is important to remember that investing money comes with the risk that you can get back less than you started with. You might want to alter your investment strategy in pensions and ISAs according to when you want to access the money in each.
Have you maxed out your allowances?
You should consider the annual allowance limits for each option.
For example, you could use your available pension contributions allowance first, particularly if you are a higher-rate taxpayer and can benefit from 40% or 45% tax relief. Then, if you have any money left to invest, use your ISA allowance.
Learn more about our Stocks and Shares ISA
Learn how to make the most of your Stocks and Shares ISA with our useful guides.