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?

Usually, 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.

Pensions can deliver better outcomes for most retirement savers, driven by these tax relief on contributions, according to analysis by pensions provider Standard Life.

A £20,000 investment in an ISA, for example, could grow to around £29,605 over ten years, based on an assumed return of 4% per year after charges. By comparison, a pension contribution with the same £20,000 net cost, boosted by tax relief, could grow to around £37,006 for a basic‑rate taxpayer and up to £49,341 for a higher‑rate taxpayer.

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%. Some employers will match your contributions too.

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.

Even changes to salary sacrifice in 2029, which will see the amount workers can add into workplace pensions before having to pay National Insurance capped at £2,000, should not deter savers from adding to their pension pots too much, said Helen Morrissey, pensions expert at Hargreaves Lansdown.

“The income tax savings remain and contributing to a pension is still a hugely tax efficient way to save for your retirement,” she 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.

In April 2027, the cash ISA annual allowance will be lowered from £20,000 to £12,000 for those under the age of 65. The chancellor is decreasing the limit in a bid to get more savers putting their cash into stocks and shares. This reduced cash ISA limit won’t apply for over 65s.

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 soon 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.

For most estates, unused pension funds will continue to pass on free of IHT post April 2027, as total estate values typically fall below the nil-rate band. A surviving spouse with a home can benefit from a combined threshold of up to £1 million.

Neil Jones, tax and estate planning specialist at Standard Life, said: “For those focused on wealth transfer, estates that may face IHT should remember that the upfront tax relief on pension contributions may offset any additional tax payable under the new rules. Seeking advice from a professional financial adviser remains the best way to navigate estate planning options.”

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.

Sarah Pennells, consumer finance specialist at Royal London, said: “The ideal situation is to be able to save into a pension for your retirement savings and into ISAs for your medium to long-term saving goals.”

What about Lifetime ISAs vs pensions?

Lifetime ISAs (LISAs) work in a different way to other ISAs, and can be a valuable retirement option for some savers. You need to be aged between 18 and 39 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.

Chancellor Rachel Reeves announced in the Autumn Budget that the government is publishing a consultation on the launch of a new, ‘simpler’, ISA product to help first-time buyers onto the property ladder, which will be offered to people in place of the LISA.