ISAs vs pensions – which is better for retirement?

Pensions and ISAs are both powerful savings tools which shelter your income and capital gains from the taxman, but which is the better option when saving for retirement?

In most cases, the answer to this question is your pension. Pensions offer valuable tax perks on the way in – something called pension tax relief. ISAs do not come with this perk.

Pension tax relief is essentially a tax refund, paid at your marginal rate. If you are a basic-rate tax payer, you qualify for 20% relief on contributions up to a certain threshold (more on that later).

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It means for every £80 you contribute to your pension, HMRC will gross it up to £100.

Higher and additional-rate taxpayers get 40% and 45% respectively, meaning they only have to contribute £60 or £55 to get a £100 contribution. ISAs do not come with the same benefit.

For those paying into a workplace pension scheme rather than a separate personal pension or SIPP, there are additional perks such as employer contributions.

Under auto-enrolment rules, 8% of your salary will be paid into your pension pot each year. You typically contribute 5% of your wages, while your employer contributes 3%. In some instances, employers will be more generous.

For this reason, prioritising your workplace pension over your ISA is a “smart first step,” according to Robert Cochran, retirement expert at Scottish Widows.

“Many employers will match your contributions over and above the minimum payment they automatically put you in at. This is an immediate, guaranteed return on your investment that you won’t find anywhere else,” he said.

ISA pros and cons

Although ISAs are less tax-efficient than pensions overall, they do offer some other perks.

First of all, they are straightforward in that everyone gets an allowance of £20,000 a year, regardless of their income. You then pay no tax on capital gains, interest or dividend income within the account – the same as with pensions.

You can split your annual £20,000 allowance between different types of ISAs: cash ISAs, stocks and shares ISAs, innovative finance ISAs and lifetime ISAs.

Investing typically generates better returns over the long run than cash, but you should be willing to put your money away for at least five years to help ride out any short-term volatility. We take a closer look in our guide on saving versus investing.

Another important benefit that ISAs have (but pensions lack) is flexibility.

In most cases, you can take money out of an ISA as and when you see fit, irrespective of your age (although the rules are different with lifetime ISAs). Meanwhile, most people can only dip into their pension once they turn 55.

One final difference between pensions and ISAs is that you don't pay any tax on ISA withdrawals. Meanwhile, pension withdrawals are taxed at your marginal rate.

Despite this, pensions are still more tax-efficient overall, as most people drop down a tax band when they retire. This means many people will benefit from higher or additional-rate tax relief on contributions, before becoming a basic or higher-rate taxpayer in retirement.

Pension pros and cons

In addition to the tax perks outlined previously, pensions have some unique characteristics that are worth bearing in mind.

For example, you are allowed to take the first 25% of your pension as a tax-free lump sum. You can either take this as a one-off payment or access it in instalments. It is only after this point that income tax is charged on withdrawals.

Historically, pensions have offered valuable inheritance tax perks as well, but this is set to come to an end in two years’ time after changes announced in the 2024 Autumn Budget.

From April 2027, pensions will be brought inside the inheritance tax net. This means beneficiaries may need to pay 40% inheritance tax, as well as income tax on any withdrawals that exceed the personal allowance.

Topping up your pension used to be a slam-dunk if you had any leftover cash after paying for the essentials, but some savers may start to rethink this strategy once they have built up a big enough pot to cover their expected retirement costs.

“The spectre of ‘double taxation’ could result in millions of people paying a minimum tax rate of 64% on inherited pensions, resulting in a real risk that confidence in pensions will be seriously eroded,” said Tom Selby, director of public policy at AJ Bell.

A combined approach to pensions and ISAs

While pensions generally offer more generous perks overall, savers can use a combination of pensions and ISAs to achieve their financial goals.

For example, the flexibility associated with ISAs means they are a good place to stash money you might need to access before turning 55.

ISAs can also come in handy for high earners once they have maximised their annual pension tax relief allowance. Here’s a quick summary of the rules:

• Annual pension allowance: The annual pension allowance is £60,000 for most people. This includes the value of your employer’s contributions as well as your own, and the value of tax relief. However, there are some exceptions.
• Lower earners: If you earn less than £60,000, you can only get tax relief on up to 100% of your annual earnings.
• Higher earners: Likewise, if you earn more than £260,000 in “adjusted income” (salary plus the amount your employer pays into your pension), you start to lose some of the £60,000 allowance. You lose £1 of the allowance for every £2 you earn over the threshold, until the allowance drops to a minimum of £10,000.

Given these rules, it could make sense to pay into an ISA rather than a pension once you have maximised your annual pension allowance. Just make sure you aren’t sacrificing any valuable employer contributions as a result.

Cochran summarises the key guidelines as follows: “ISAs are best used if wanting to build an emergency fund, saving for short to medium-term goals, providing supplementary retirement income alongside pensions, and adding to savings after maximising your pension contributions.”

In most other circumstances, a pension is best.

What about lifetime ISAs vs pensions?

Lifetime ISAs (LISAs) work in a different way to other ISAs, and are a valuable retirement option for some savers. You need to be aged 39 or under to open one, and savers receive a 25% bonus on their savings, up to a maximum of £1,000 per year – a bit like pension tax relief.

LISAs were designed to help young people save for either a first home or retirement.

It could be tempting to use a LISA to save for old age – but is it a good idea?

As a rule of thumb, if you’re employed, then paying into your workplace pension and reaping the benefits of employer contributions plus tax relief is the better option. The value of these perks is likely to outweigh the lifetime ISA's 25% government bonus.

However, if you have maxed out your annual contributions on your workplace pension and want to save or invest more, a lifetime ISA could be a good option. This will provide additional tax-free income in later life. Remember that withdrawals from a LISA are free of income tax, whereas pension withdrawals are taxed at your marginal rate.

If you are self-employed, your tax status and personal situation will come into play when working out which is the better option for you.

Self-employed higher-rate taxpayers will benefit more from paying into a pension (the tax relief wins over the lifetime ISA bonus). For self-employed basic-rate taxpayers, it is not as clear cut. You will need to work out which scheme is best for you based on your individual circumstances.