Isa vs pension: how to know what's right for you

Individual savings accounts (Isas) and pensions are both key for tax-efficient financial planning. With the capital gains and dividends allowances dropping as of this April, the importance of tax wrappers is set to increase even further, and people who have the financial capacity to contribute to both up to the respective limits should certainly consider doing so.

But with the Isa allowance at £20,00 a year and the annual contribution limit for pensions currently at £40,000 (due to increase to £60,000 from April as a result of Jeremy Hunt's Spring Budget), for many it will be a matter of choosing which to prioritise. This largely depends on your financial goals.

The basics

In the accumulation phase - when you are saving - pensions have a huge advantage in the form of tax relief on contributions. With income tax bands frozen until 2028, a growing number of people are being pushed into the higher tax bracket, which also means they can get a higher tax relief on pension contributions. If you pay income tax at the 40 per cent rate, making a £10,000 gross pension investment will only cost you £6,000 in foregone after-tax income.

Tax relief boosts your investments, and thanks to compounding, the longer your time horizon, the bigger the boost. Assuming an annual 5 per cent rate of return, £6,000 in an Isa becomes £9,900 after 10 years; the same figure in a pension, plus tax relief at the 40 per cent rate, grows to £16,500 (note that you will need to claim extra relief above the 20 per cent rate in your self-assessment). Lisa Caplan, director of OneStep Financial Planning at Charles Stanley, also notes that you only get tax relief on earned income - not rent, pension income, dividends, or interest, which is something to keep in mind.

Once you have made your contributions, your investments grow in a tax-free environment whether they are in an Isa or in a pension, so you do not need to worry about capital gains or dividend tax. Finally, in the decumulation phase, Isas allow you to draw from your investments tax free, while pensions are subject to income tax after the initial tax-free lump sum of just over £268,000.

Considering all of this, at a basic level a pension will typically be more tax efficient than an Isa, albeit depending on the rate of tax relief you get when you contribute, your time horizon and the income tax rate you pay when you draw from your investments, as the table below shows. Pensions are at their most advantageous when your initial tax relief rate is higher than your income tax rate in the decumulation phase, and with a fairly long time horizon - which, unsurprisingly, reflects many people’s retirement planning circumstances.

Access and flexibility

The main drawback of saving in a pension is that you cannot access the funds until you are 55 (due to rise to 57 in 2028), which is why Jason Hollands​​​​, managing director at Evelyn Partners, says that “for most people pensions are best reserved for their intended purpose – as a retirement fund”.

“Where Isa saving does win out hands down is flexibility,” he adds. “Isas can be accessed any time, with no tax on withdrawals, so are more suited to medium-term goals like paying off a mortgage, funding children’s education fees or a rainy-day fund.” 

Put in the simplest way, focusing on your pension has the largest benefit for higher income taxpayers who are saving for their sixties, says Caplan, while Isas are best for people who may need access to their savings and are uncertain when that will be. 

As well as depending on your circumstances, the equation changes a little with age. When you are young, saving into a pension really gives your investments a lot of time to grow before retirement, and spares you from having to make much larger contributions later in life to catch up. On the other hand, you are also likely to have a number of short- and medium-term goals for which you will need earlier access to your money.

As you approach 55, the access issue becomes less relevant, but there might still be reasons to prioritise contributing to your Isa over your pension. Accessing your pension for the first time can result in triggering the money purchase annual allowance (MPAA), which reduces the amount of annual tax-free contributions you can make into your pension to £4,000 (due to increase to £10,000 from 6 April). Having a significant rainy day fund in your Isa ensures that if anything happens, you don’t need to start drawing from your pension before time - although note that the MPAA is not triggered if you take the tax-free lump sum and crystallise your pot but avoid starting drawing income from it.

Another reason to prioritise your Isa used to be the lifetime allowance, which currently limits the total amount you can hold in your pension tax-free to £1,073,100. But from 6 April, the the tax charge for breaching it will be removed and the allowance itself will be scrapped from April 2024. This means that there will be no maximum limit on how much you can hold into your pensions, just like there is no lifetime limit on Isas - although the idea of introducing one occasionally comes up, most recently in a proposal by think tank the Resolution Foundation, which argued for a £100,000 limit on tax-free Isa savings earlier this year.

Investment strategy

From a tax perspective, there is not necessarily a difference between the investments that are better to hold in your Isa and those for your pension, as they are both tax-free environments. 

But depending on what you are using them for and on your age, the most suitable investment strategy may vary. Laith Khalaf, head of investment analysis at AJ Bell, explains: “The difference between investing a pension and an Isa boils down to the differing investment horizons these products might hold for saver.”

“Generally speaking a pension will be more long-term in nature, which favours a more risk-hungry, equity based approach,” he says, while a stocks and shares Isa might be used for more medium-term financial goals, “in which case a lower risk approach might well be in order.” For example, multi-asset funds or defensive instruments are better suited than equities to protect yourself from large market downturns on a five-to-ten years time horizon.

More than about the products themselves, it comes down to what you intend the money for. There is nothing stopping you from keeping some Isa funds for later in retirement with a fairly aggressive investment strategy - just as, once retirement approaches, you might want to start derisking a portion of your pot. 

Where to draw from

So far we have discussed what to prioritise in the accumulation phase. Once you turn 55, if you have substantial savings in both your Isa and your pension and want to retire early, reduce your hours or you have some big expense coming up, you will have to decide where to draw the money from instead. 

Outside of the tax-free lump sum, pensions are often not great for chunky, one-off expenses - say, for example, refurbishing your house or going on a particularly big holiday. It might push you into a higher income tax bracket, whereas from an Isa you can draw the sum tax-free.

Another reason to preserve your pension and use your Isa first is inheritance tax planning. “Modern defined contribution pensions are a very attractive route for passing wealth on, as any remaining assets in them are not currently subject to inheritance tax,” Hollands explains. “These can be left to whomever you choose.” If you die before you turn 75, your beneficiaries will also be able to draw from the pension free of income tax, while this will apply afterwards. 

In contrast, Isas become part of your estate for inheritance tax purposes. The inheritance tax threshold is currently £325,000, potentially increasing to £500,000 if you leave your home to your children or grandchildren. If you think your estate will be close to or over the threshold, it makes sense to draw from your Isa first.

When a person dies, their surviving spouse or civil partner can get a one-off additional Isa allowance, equivalent to the value of their deceased partner’s Isas, so they can reinvest the amount in their own name. This was introduced in 2015 and is called an additional permitted subscription.

Finally, when it comes to drawing income, using a combination of Isas and pensions can often be an attractive option. For example, you can start the tax year by drawing from your pension to use up your personal allowance, potentially up to the basic rate threshold; and then shift to your Isa for any additional income that you might need, so that you avoid the higher income tax rate even if your expenses exceed the relevant threshold.