Pensions vs ISAs – Which is best for retirement?

Usually, when considering retirement savings, most people's first thought is to contribute to a pension and rely on this during their later stage of life. However, an option that is often underutilised is an Individual Savings Account (ISA). Both pensions and ISAs offer distinct advantages and considerations for retirement, providing individuals with the option to tailor their savings strategy and retirement plans based on their own specific needs and circumstances, but what is the best option for your retirement? 

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First let’s start with the basics. 

What is an ISA?  

An ISA is an account that offers tax benefits on any income or gains generated. Simply, both growth and income are tax-free and are not liable to Capital Gains Tax (CGT) or Income Tax. Think of it like a tax-free wrapper that you wrap around your savings or investments. There are currently five types of ISAs designed for different financial objectives: Cash ISA, Stocks & Shares ISA, Innovative Finance ISA,  Lifetime ISA and Junior ISA. The ISA allowance for the current tax year is £20,000.  

Cash ISA 

A cash ISA is, as the name suggests, a cash-based savings account. Much like standard savings accounts they come in different forms including Easy Access, Notice ISAs and Fixed Rate ISAs.  

Stocks & Shares ISA 

A stocks and shares ISA allows you to invest your money across a variety of markets and sectors, offering wider investment opportunities and potential for growth. It comes with a greater degree of risk and your investments may go down as well as up in value. 

Innovation ISA 

An Innovative Finance ISA or IFISA is designed to enable those who are interested in peer-to-peer lending to do so via an ISA wrapper. These are complex products with significant risks attached and will not be appropriate for everyone.  

Lifetime ISA 

A Lifetime ISA or LISA is open to individual’s aged between 18-40 and was designed for young people looking to save for their first home or their retirement.  

Providing the LISA has been opened before age 40, you can contribute to it up until your 50th birthday and you can opt to save into a stocks and shares LISA, a cash LISA or a mixture of both. The annual LISA limit is £4,000 and the government will add a 25% bonus to the amount you save.  

If you do not use your LISA for a property purchase, you can access the funds penalty-free from your 60th birthday and the proceeds can be utilised in retirement.  

Junior ISA 

A Junior ISA can be opened at birth and is controlled by a parent or guardian until the child turns 16 (although withdrawals cannot be take until age 18).  The current annual JISA allowance is £9,000. You can make payments to a cash JISA and a stocks/shares JISA per tax year (but can only hold one of each type). 

What is a Pension?  

There are two main types of pensions: Defined Contribution Pensions and Defined Benefit Pensions. Defined Contribution Pensions involve employees and employers making contributions, which are then invested to generate returns. Defined Benefit pensions (also known as Final Salary Pensions) are now less common and generally guarantee a fixed, inflation linked income for life.  

What are the differences between a Pension and an ISA?

When comparing pensions and ISAs for suitability, each has its own advantages and considerations: 

Employer contributions 

Pensions benefit from employer contributions, where employers are obligated to contribute at least 3% of an employee's annual salary. ISAs, on the other hand, do not receive any employer contributions.  

Withdrawals and access 

ISAs are generally more flexible when it comes to withdrawals, allowing you to access funds should you need them (some with penalties attached and with Lifetime ISAs having specific withdrawal rules for saving towards a first house or retirement). Pensions have stricter withdrawal rules, with no access to funds until reaching the age of 55, increasing to 57 in 2028.

Inheritance tax 

Inheritance tax (IHT) is an important consideration when planning for retirement. Monies held within a pension wrapper are usually outside of the estate for IHT purposes and therefore avoid this tax, ordinarily levied at 40%. 

Providing your pension provider has adopted the ‘pension freedoms’ introduced in 2015, pensions can be a useful inter-generational planning tool. If your pension offers flexi-access drawdown on death, the monies can stay within a pension and therefore outside of your beneficiaries’ estate, and so on through the generations. Ensuring your pension offers flexible death benefits is of high importance if IHT is a concern to you and your family. In contrast, an ISA is included in the value of your estate and is therefore subject to IHT if your estate exceeds the Nil Rate Bands. The value of your ISA can be passed on to a spouse or civil partner by using what’s known as additional permitted subscription (APS).

Tax relief 

Pensions offer tax relief on contributions at 20%, meaning that a contribution of £100 only costs you £80. Additional tax relief is available for higher and additional rate taxpayers at 20% and 25% respectively. 

Contribution limits 

ISAs have a contribution limit of £20,000 per annum, while pensions allow you to contribute up to a maximum of £60,000 tax efficiently per annum. The maximum you can personally contribute in each tax year is limited to the amount of relevant UK earnings (for example, employment or self-employment income) in that year. Additionally, if you haven't used your full allowance in previous tax years, you can utilise the "carry forward" option to contribute more than £60,000 to your pension in the current tax year, by using unused allowances from the past three years, providing you have the earnings to support this level of contribution.

Which option is best for your retirement?  

The choice between a pension and an ISA ultimately depends on individual circumstances and preferences. Pensions are ideal for those who are still working and can benefit from employer contributions and tax relief on personal contributions. ISAs offer greater flexibility and earlier access to funds, making them more suitable for individuals valuing liquidity and potentially requiring access to their savings before retirement age. Combining ISAs and pensions allows individuals to maximise the advantages of both options: benefiting from employer contributions while working, taking advantage of tax advantages through pension contributions, and enjoying investment flexibility and pre-retirement access to funds through ISAs.  

At The Private Office, our retirement planning specialists can assist with providing you with a clear breakdown of your retirement position and what steps you can take to maximise your earnings in retirement, to discuss how we can help with your individual circumstances, get in touch to arrange a free consultation. 

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Please note: Pensions are a long-term investment; investment returns are not guaranteed, the value of your investments can go down as well as up and you may get back less than you originally invested.

The Financial Conduct Authority (FCA) does not regulate tax advice.