Are you thinking about saving for retirement? If so, it’s worth asking yourself what your priorities are, how much you want to save, what flexibility you need, and ultimately: whether you’d be better off using an ISA or a pension.
The products are both tax-efficient, and each come with their own pros and cons.
While a pension seems like the obvious vehicle for saving for your golden years, an ISA could be a better choice. ISAs have risen in popularity over recent years. A total of 11.7 million cash ISAs and stocks and shares ISAs were paid into during 2022/23, according to the latest official figures. This is up from 11 million a year earlier.
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We run through the things you need to consider when it comes to saving for retirement, including tax rules to be aware of.
Pension pros and cons
There are a couple of areas where pensions offer more benefits than ISAs.
First, if you have the option of joining a pension scheme at work, doing so will mean benefiting from a pension contribution from your employer. In most cases, the minimum amount your employer must contribute is 3%. The current minimum total contribution is 8%, meaning you would then top your employer’s contribution up with 5%.
A pension also allows you to take 25% of your fund as a tax-free lump sum and offers a real advantage when it comes to inheritance tax (IHT) planning. In many cases, unused pension savings can be passed on to your heirs without counting towards the value of your estate.
The next thing to consider when it comes to pensions is the allowances. Pensions have an annual allowance of £60,000 – which includes the value of your employers’ contributions as well as your own, and the value of tax relief. This means most people can pay in up to £60,000 across their different pension pots each tax year and benefit from pension tax relief.
If you earn less than £60,000, note that you can only get tax relief on pension contributions worth up to 100% of your annual earnings. If you’re a higher earner with an income above £200,000 a year, your annual allowance becomes tapered and might decrease to as little as £4,000 for the tax year.
Something else to consider is pensions’ lack of flexibility. You can only get your money once you turn 55 (rising to 57 in 2028). If you do start drawing down from your savings, your annual allowance falls to just £4,000. That’s a pain for the growing number of people looking to reduce the amount of work they do as they approach retirement. You also pay income tax on pension income.
Finally, if you’ve had many jobs throughout your life, you might also end up with many different pots of savings. Pension consolidation can be time-consuming and bureaucratic. All of these things considered, might savers be better off giving up on pensions altogether and using ISAs instead to save for old age?
ISA pros and cons
ISAs 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 - which is the same with pensions.
You can split your annual £20,000 limit between different types of ISAs: cash ISAs, stocks and shares ISAs, innovative finance ISAs and lifetime ISAs.
A key difference with pensions is that you don't pay any tax on ISA withdrawals. The flipside is that there is no tax relief when you make contributions (except for lifetime ISAs, which benefit from a government top-up).
In most cases, you can take money out of an ISA as and when you see fit, irrespective of your age, so if you wanted to dip into your pot before you turned 55 you would be able to (although the rules are different with lifetime ISAs).
That said, there are a couple of areas where ISAs struggle to compete with pensions, namely when it comes to workplace contributions.
Opting for an ISA instead of a workplace pension will mean you’re missing out on that extra boost from your employers. Additionally, ISAs fall within the IHT net, potentially leaving your heirs with a nasty headache and a lot of paperwork.
What about lifetime ISAs vs pensions?
Lifetime ISAs are designed to help young people save to buy a first home, or for retirement. 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.
It could be tempting to use a lifetime ISA (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 are likely to outweigh the lifetime ISA's 25% government bonus.
If you’ve maxed out annual contributions on your workplace pension, and you want to save or invest more, a lifetime ISA could be a good option. This will provide additional tax-free income for you 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’re self-employed, your tax status and personal situation will come into play to work out which is a 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). It’s not as clear cut for self-employed basic-rate taxpayers though, and it’ll be about working out which scheme works for you.
ISAs vs pensions: the verdict
ISAs are certainly a popular choice for many people, but using them instead of a pension to save for retirement does have its drawbacks - especially in terms of tax relief, and the fact ISAs are liable for inheritance tax.
In an ideal world, savers would take advantage of both ISAs and pensions as they plan for old age, perhaps maxing out their pension pots before turning to ISAs. And in retirement, spending the ISAs before pensions in order to plan for IHT as efficiently as possible.
But for anyone lacking the resources to pursue both routes to retirement, pensions still retain an edge over ISAs.
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