Pensions vs. ISAs

When it comes to long-term savings in the UK, pensions and ISAs (Individual Savings Accounts) are two of the most popular options. Both offer unique advantages for securing your financial future, yet they work very differently. As an independent financial adviser, I often guide clients through the benefits and limitations of each option. Here’s an in-depth look to help you understand which savings vehicle might be best suited for your financial goals.

What is a Pension?

A pension is a tax-advantaged savings plan designed specifically for retirement. You can choose a workplace pension, a self-invested personal pension (SIPP), a personal pension, or a stakeholder pension. Pension contributions provide substantial tax relief. In the UK, for every £100 you contribute to a pension, the government adds £25 (for basic rate taxpayers), making pensions a powerful way to reduce taxable income. Higher and additional rate taxpayers can claim back more via their tax return.

What is an ISA?

An ISA is a tax-free investment wrapper that allows you to save up to £20,000 per tax year without paying income or capital gains tax on the investment returns. You would pay into your ISA from your net income (after tax). There are several types of ISAs, including Cash ISAs, Stocks and Shares ISAs, Lifetime ISAs, and Innovative Finance ISAs. Unlike pensions, ISAs are not specifically intended for retirement and offer more flexibility with withdrawals.

Key Factors to Consider

Let’s dive deeper into some of the key factors to consider when deciding between pensions and ISAs.

1. Tax Benefits

• Pension: When you contribute to a pension, the government adds tax relief to your personal (after-tax) contributions. For example, a basic rate taxpayer (20%) would receive an extra £20 for every £80 invested. Higher rate (40%) and the additional rate (45%) taxpayers receive even greater tax relief, but they may need to claim part of it via their self-assessment. Employer contributions are generally tax-free, and you can deduct those from corporation tax. If you’re a director, this is a good way to save for your retirement, as you don’t pay income tax or corporation tax on the contributions (but will not get the government tax bonus)
• ISA: Contributions to an ISA are made from post-tax income, meaning there is no immediate tax relief. However, any interest or gains made within the ISA are tax-free, and withdrawals are also free from income tax and capital gains tax. You cannot have an ISA for a business.

Conclusion: Pensions tend to offer stronger tax benefits at the point of contribution, especially for higher earners.

2. Access to Funds

• Pension: Generally, pension funds cannot be accessed until age 55 (57 from 2028). You can take 25% of your pension tax-free, but the rest is taxable income. You will be able to draw your retirement income in several ways, including flexi-access drawdown or annuity.
• ISA: ISAs are much more flexible, allowing you to withdraw funds at any time without penalty or tax implications, making them a popular option for individuals who may need access to funds before retirement. Many ISAs are also ‘flexible’ and would allow withdrawals and deposits in the same tax year without losing the annual allowance.

Conclusion: ISAs provide greater flexibility, which may be beneficial if you want the option to access funds before retirement.

3. Contribution Limits

• Pension: The annual allowance for pension contributions is £60,000 (as of the 2024/25 tax year), although this can be reduced if you earn more than £200,000 (due to the Tapered Annual Allowance). Additionally, lifetime allowances have been abolished as of 2023, removing limits on overall pension savings. You can also benefit from the carry-forward rule where you can use your previous years’ (up to 3 years) annual allowance. For example, If you have not paid into a pension but were a member of a pension scheme for the last three tax years, the gross amount you could contribute could be as high as £200,000. Please note, that you would need earnings of a minimum of that amount.
• ISA: You can contribute up to £20,000 per tax year across all ISAs, whether that’s a Cash ISA, Stocks and Shares ISA, Lifetime ISA, or Innovative Finance ISA.

Conclusion: Pensions allow for higher annual contributions, ideal for those seeking to maximise their tax-advantaged retirement savings.

4. Investment Options

• Pension: Most pension schemes, including SIPPs, offer a wide range of investments such as stocks, bonds, funds, and other financial products. However, workplace pensions may have limited options depending on the provider.
• ISA: Stocks and Shares ISAs allow investment in a variety of assets like individual stocks, mutual funds, and ETFs. Some Cash ISAs offer fixed rates for those preferring savings over investments.

Conclusion: Both pensions and ISAs offer substantial investment opportunities. SIPPs and Stocks and Shares ISAs are particularly suitable for those looking to actively manage their portfolios.

5. Estate Planning and Inheritance Tax (IHT)

• Pension: Pension pots currently are not counted as part of your estate, so they can be passed on to beneficiaries tax-efficiently. However, from April 2027, pensions will be included in the calculation for Inheritance Tax. Additionally, if you pass away after 75, your beneficiaries may need to pay income tax on any drawdown or income. If you pass away before the age of 75, they can inherit the pension free from income tax. Your spouse or civil partner can still inherit the pension free from IHT (subject to income tax above).
• ISA: ISA funds are part of your estate and could be subject to inheritance tax at 40% if your estate exceeds the IHT threshold (£325,000 for individuals, or up to £650,000 for couples). Your ISA allowance can be passed to your spouse or civil partner via an Additional Permitted Subscription (APS). This allows them to inherit your ISA’s tax-free status. They can receive the same value as your ISA as an extra allowance on top of their own ISA limit, meaning they can continue to invest or hold the money in a tax-efficient manner.

Conclusion: Both pensions and ISA will be subject to Inheritance Tax above the threshold, both can be inherited by a spouse free of Inheritance Tax.

6. Long-Term vs. Short-Term Goals

• Pension: Designed specifically for retirement, pensions are a long-term investment vehicle that encourages you to keep your money invested until later in life.
• ISA: ISAs are versatile and can serve both short- and long-term savings goals. Whether you’re saving for a home, an emergency fund, or general investments, ISAs can be used as you see fit.

Conclusion: ISAs are more adaptable to different savings goals, while pensions are optimal for retirement planning.

So, Which One is Right for You?

Choosing between pensions and ISAs isn’t always straightforward, and it largely depends on your unique financial situation and goals. Here’s a general guide:

• Pensions are best for those with a primary focus on retirement, particularly higher-rate taxpayers who can benefit from greater tax relief and those looking to save more than the ISA annual allowance.
• ISAs are suitable for individuals looking for flexible access to savings, tax-free growth, and investment options with no restrictions on when they can withdraw funds.

In many cases, a combination of both a pension and an ISA might be the best approach. This allows you to maximise tax benefits, use up all your allowances, retain flexibility, and balance short- and long-term goals effectively.

Final Thoughts

There’s no universal solution when it comes to saving for your future. The decision between pensions and ISAs depends on how you prioritise factors like tax benefits, access to funds, investment choice, and estate planning. If you’re unsure, seeking advice from an independent financial adviser can be invaluable. At Glade Financial, we help clients assess their individual needs and craft a balanced strategy that leverages the strengths of pensions, ISAs, or a combination of both, so they can achieve a more secure and tax-efficient future.