ISA or pension – pay tax now or later
Pensions and individual savings accounts (ISAs) are two good ways for UK taxpayers to save for retirement. Both pensions and ISAs provide value by having tax advantages. However, their respective tax advantages are applied at different times during their existence. That adds some complexity to the decision about which is better to use when saving for retirement. Or do both have a place?
We outline some of the similarities and differences between the two savings tools to help decide where is best to save your money.
Pensions vs ISAs
How do pension tax benefits work?
The major advantage of saving into a pension is that the government grants tax relief when you pay money into your pot. The pension tax relief you can get is based on the rate of income tax you pay.
- Basic-rate – get 20% pension tax relief
- Higher-rate – get 40% pension tax relief
- Additional-rate – get 45% pension tax relief.
The pension tax relief only applies up to the Annual Allowance (set at £40,000 for 2022-23*), any contributions above that amount are taxed.
So if you’re a basic rate taxpayer, then every £80 you contribute to your pension fund increases the fund by £100. Higher rate taxpayers need only contribute £60 to gain £100 and additional rate taxpayers increase their funds by £100 for every £55 contributed.
A further benefit for those that belong to a company pension scheme is that the employer may top up the pension pot over and above the individual’s contribution, sometimes based on the more you pay then the more they pay. You’re effectively getting free money from your employer that will let your pension pot grow faster. Check with your HR department for the options available or get advice.
You do not pay any capital gains tax or income tax while the money remains in your pension pot.
How do ISA tax benefits work?
With an ISA you do not get any tax relief up front when you pay money in. Typically the funds you deposit have been taxed already.
Similar to a pension, you also won’t be due any tax on the interest earned or capital gains you make on your investments while the funds are in the ISA.
The big difference is that you do not pay capital gains tax or income tax when you withdraw any funds from the ISA.
There is a maximum you can pay into ISAs each tax year. This stands at £20,000 in the current tax year (2022/23*). A new ISA allowance starts at the beginning of each new tax year, any not used by the end of the tax year cannot get carried over.
Some ISAs have rules allowing you to withdraw and re-deposit cash within the same tax year, as long as the net deposit does not exceed the annual limit. These are called flexible ISAs and can be used in a similar way to saving accounts, other than their tax benefits. However standard ISAs (and especially those aimed at longer-term investing) do not allow this and each deposit counts towards the annual limit – so check the rules carefully.
How the money grows
Your pension provider (or you if it’s a SIPP) will typically invest the money in your pot into a wide range of investment funds to spread risk. With all investments, there is always a risk that they will go up or fall. Pension providers invest for higher risk/higher return initially, but as you approach retirement it is usual to consider moving the money into lower-risk funds to avoid risking a significant drop in value just before you retire.
The big benefit of a pension is that as your money goes into it the government, and sometimes your employer, also tops it up. Then, with astute investment decisions the money gets invested in shares, funds and bonds should grow in value, plus any dividends earned get reinvested to grow another time. This compound growth should then snowball, with some ups and downs, into a neat sum for you to use in retirement.
You can have more than one ISA, and different types of ISAs. You can use this fact to allocate your money into either cash, investments, peer-to-peer lending or a combination of those. The decision will be based on market conditions, your views on risk or how close you are to retirement.
Each investment approach carries a different level of risk with varying impacts on the value of your ISAs. Money invested in a Cash ISA is not at risk of changes in the markets but gets lower rates of return that can easily get eroded by inflation. ISAs invested in stocks, shares or lending typically have higher returns, but their values are more at risk of changes in the investment markets.
A Cash ISA simply earns interest at a set rate. However, with investment ISAs the same decisions on how and when to allocate the money need to be made as with pensions. You can do this yourself, or take guidance from the investment service you use. They may have a selection of portfolios to choose from, based on the level of risk and reward you are comfortable with. Then the money invested in shares, funds and bonds should grow in value, plus any dividends earned get reinvested to grow another time. Similar to pensions this compound growth should snowball, with some ups and downs, into a neat tax-free sum for you to use in retirement.
How to access your pension or ISA money
Once the money is held in a pension it can only be accessed when you reach a certain age. As it stands that is at age 55, but also check with the pension provider that it conforms to their specific rules for the pension plan.
At that time you can withdraw up to 25% of the money built up in the fund as a tax-free lump sum. You then have up to 6 months to start taking the remaining 75%, which will be taxed at your usual rate.
There are different ways to take out the rest of your pension pot:
- Withdraw all or some of it as cash
- Buy a product (known as an ‘annuity’) that gives you a guaranteed income for a fixed period, for life, or even for your spouse or partner after you die
- Invest it to get a regular, adjustable income (known as ‘flexi-access drawdown’) in the form of withdrawals or short-term annuities.
You may continue to work and earn and contribute to your pension fund after you retire, though rules do apply. Money withdrawn from a pension will be added to your salary or wages for calculating your income tax due, so beware of exceeding tax thresholds.
An ISA is a savings account. You are free to withdraw your savings whenever you want to without penalty. This may be subject to rules set by the bank or financial institution for fixed-term Cash ISAs, or the time it takes to sell or liquidate assets owned in investment ISAs.
All withdrawals from an ISA are tax-free.
Impact on benefits
Circumstances may change, such as losing your job, and you may have to claim benefits one day. Usually, the money in your pension pot will be excluded when assessing the level of benefits you qualify for and will remain protected while continuing to grow in value.
Should you need to claim benefits then the money in an ISA is seen as an asset you can access. This may affect your eligibility to receive certain means-tested benefits. You may need to deplete your ISAs first before being able to qualify for benefits.
Can I have an ISA and a pension at the same time?
Yes, especially as pensions and ISAs complement each other. With an ISA you can access your tax-free money anytime, including before the age of 55. Even in retirement, you can use it as a draw-down reserve or a nest egg for those special holidays or emergency expenses. At the same time, a pension can provide the certainty of a steady income stream for life, or even after.
So which is better – ISA or pension?
Pensions and ISAs are different. One is not better than the other, they complement each other. It depends on your goal for saving to determine which is more suitable. But then you probably have multiple goals, which make the other one more suitable. It’s best to combine them.
- Money saved into a pension gets topped up by the tax man and employer, so the amount deposited grows faster
- Money saved into an ISA is taxed already, so the equivalent pot is smaller.
- Within the pension fund or ISA, the money is treated the same, enabling compound tax-free growth. The pension should grow bigger faster as it starts from a bigger base thanks to the top-ups.
- Money stays in the pension until you are at least 55 years old. With an ISA you have access anytime.
- Only 25% of the money withdrawn from a pension is tax-free, the rest is taxed as income.
- All money withdrawn from an ISA is tax-free.
It’s clear that pensions and ISAs have different, complementary purposes, so it’s best to have both.