Use Isas to boost your retirement

Pensions are the bedrock of most people’s financial plan for retirement, with good reason. Your money grows in a tax-free environment and you receive tax relief on your contributions, so over the years your savings grow more quickly than they would in other types of account. Meanwhile, individual savings accounts (Isas) are better suited for financial goals that require more flexibility and might be shorter-term in nature, such as helping your children onto the housing ladder or buying a new car.

As Rob Morgan, chief analyst at Charles Stanley, sums up: “Pensions offer much greater tax advantages up front, especially for higher-rate taxpayers, but you can’t touch your savings until the age of 55 currently, and this age is set to rise. Isas have fewer tax advantages up front but provide the flexibility to be able to withdraw money at any time tax-free.”

However, Isas can also be used together with pensions as part of your retirement planning and come in handy in a number of circumstances.

Topping up your income

Pensions are at their most advantageous when you contribute as a higher-rate taxpayer and later draw down as a basic-rate taxpayer, because you enjoy tax relief on the contributions but are later charged income tax on the withdrawals (excluding the 25 per cent lump sum that can be taken tax-free). For example, if you qualify for higher-rate relief and contribute £1,000 to a pension, you immediately receive an additional £250 in tax relief and can claim another £250 in your self-assessment tax return, both of which you can invest back into your pension. If you then retire years later and take out this £1,500 sum as a basic-rate taxpayer, you will only be charged £225 in income tax, meaning your original £1,000 contribution has effectively transformed into £1,275. This is a nice boost, even before accounting for investment growth.

But things change a little if you have a higher income in retirement. If you withdraw £1,500 from your pension as a higher-rate taxpayer, you only keep £1,050 after tax: a much smaller gain on your £1,000 contribution. If you are a basic-rate taxpayer at the time of contributions but a higher-rate taxpayer in retirement, withdrawals will see you receive less than you originally contributed (once tax is factored in).

This is a worst-case scenario and not a very common one, because people are typically more income-rich during their working lives than they are in retirement. Still, the threshold for the 40 per cent rate of income tax has been frozen at £50,270 since the 2021-22 tax year, so it is shrinking quickly in real terms, and it isn’t that hard to exceed.

And there are plenty of reasons why you might be income-rich in retirement, too. The full state pension, which increases to £11,502 a year on 6 April 2024, already takes up a lot of the £12,570 personal allowance. If you have a defined-benefit pension or income from a rented property, you might get close to £50,270 quite quickly. Additionally, if you have already taken your 25 per cent tax-free lump sum, you have less tax-free income from your pension to play with. And while couples have more flexibility thanks to double allowances, single retirees' expenses will be proportionately higher and their financial planning options more limited.

In all these situations, Isas come to the rescue. Ian Futcher, financial planner at Quilter, notes Isas are “an advantageous option for topping up pension income”. He adds: "by utilising funds from an Isa instead of increasing pension withdrawals, people can manage to keep their taxable income low, thereby minimising their overall tax liability."

For example, you could reach the higher-rate threshold of £50,270 via your state pension and personal pensions. Income between £12,570 and £50,270 will be drawn at a 20 per cent tax rate. Anything you might need on top of that could be taken from an Isa free of tax. The chart below shows a tax-efficient way to enjoy a net income of £70,000 in retirement in 2024-25, without exceeding the 20 per cent rate of income tax and utilising your pensions, Isa, personal savings allowance, and capital gains and dividend tax allowances in full. To achieve this, you would need to withdraw roughly £51,692 gross from your personal pension, some £12,923 of which would come from the 25 per cent tax-free cash lump sum. Including the new full state pension, you would accrue a total income tax bill of £7,540.

A matter of access

The ability to freely access your money is a key advantage Isas offer over pensions. You can currently access your pension money from the age of 55, but this is set to increase to 57 on 6 April 2028, in line with the increase to the state pension age from 65 to 67, and could rise further still in future. If you intend to go part-time or retire before 55 or 57, you shouldn’t put all your savings in a pension, no matter how advantageous the tax relief.

“Not being able to access your pensions until 55 can limit any dreams of a really early retirement, but your Isas can come up trumps by providing you with access to tax-free money to fund your lifestyle,” says Morgan. “Even if you don’t have enough to fund yourself fully, they can provide the freedom to move to part-time or consultancy work with the peace of mind that your essential spending is covered.”

However, if you retire early and have plenty in both your Isa and pension, it can make sense to start drawing from the latter as soon as you can access it while you wait for the state pension to kick in. This is in order to make use of the personal allowance while you have no other income: the state pension will later take up most of this allowance.

Pensions are not necessarily suitable to fund a big cash purchase, especially once you have withdrawn your 25 per cent tax-free lump sum. Last year, the IC Portfolio Clinic looked at the case of Nick and William, 59 and 67, who wanted to use their pension money to upsize their £160,000 home. The pair had close to £480,000 in their self-invested personal pensions on top of an NHS pension and two full state pensions, but only about £60,000 in their Isas. “I slightly regret not contributing more to Isas as I think our pensions are bigger than we need,” Nick said. 

This made extracting the cash to buy the type of property they had their eye on, which would cost between £450,000 and £600,000, quite tricky, unless the two were prepared to stagger the withdrawals over various tax years to reduce the bill. “While pensions are very tax-efficient, especially when your income tax rate drops in retirement, in this case you would be withdrawing at a higher rate of income tax but have been funding your pots as basic-rate taxpayers. This means your pensions are not the most tax-efficient vehicle you could use,” David Gibb, chartered financial planner at Quilter, told Nick and William. He suggested that the two consider a smaller property instead, perhaps worth £300,000 or so, which would give them more financial flexibility in the future.

There are other limits on pensions. If you find yourself accessing your pension earlier than planned but then have some extra money to invest again, for example because you are self-employed or work part-time and your income is irregular, you could be subject to the money purchase annual allowance (MPAA), which prevents you from contributing any more than £10,000 a year to your pensions while still getting tax relief in that scenario. Isa contributions are the obvious alternative in that case.

Finally, if you are thinking about inheritance tax (IHT) planning, you may want to draw from your Isa first. This is because pensions are not typically subject to IHT when you pass away, so they are quite a tax-efficient vehicle in which to leave money to your beneficiaries.

All in all, it makes sense to use your Isa allowance in full if you can in the accumulation phase, and to combine both Isas and pensions in retirement. “A diversified approach, leveraging the benefits of both Isas and pensions, is often the most effective strategy for achieving long-term financial security and a comfortable retirement,” says Futcher.

Lisa vs pension

If all of the above applies for stocks-and-shares Isas or even cash Isas, Lifetime Isas (Lisas) are a different story. They are a hybrid product meant to help people onto the housing ladder or to save for retirement. “Pensions are known for their tax relief on contributions and higher annual limits, making them a robust vehicle for retirement savings,” says Futcher. “Conversely, Lisas, despite offering tax-free growth and government bonuses, have lower contribution limits and are less flexible in terms of withdrawal conditions.”

You can open a Lisa between the ages of 18 and 39 and contribute up to £4,000 a year until you are 50. Your contributions receive a 25 per cent cash bonus from the government. Withdrawals are tax-free, but if you don’t use the money to buy your first home, you can only access it from the age of 60. Otherwise you will be charged a 25 per cent penalty, which depending on investment growth can result in you getting back less than you originally paid in.

So for retirement purposes, Lisas are a mixed bag. They can be very useful if you intend to use Isas to top up your retirement income without incurring a tax charge later in life, because you get both the tax-free withdrawals and the government bonus. But they can’t be used for early retirement or as an emergency pot earlier in life, and the contribution limit is low.