Isas vs pensions

If you had a spare £80,000 this tax year, you could fill your annual ISA and pension allowances to the brim. But most of us don’t have this amount of spare cash, which leaves us wondering which tax wrapper to choose and prioritise. 

Here are some simple pointers to help you decide how to allocate your hard-earned savings. 

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Auto-enrollment: you’re already paying into your pension

If you’re an employee, the choice is mostly made for you because a pension is provided for under the auto-enrolment rules. Turning this offer down is a mistake because it’s really free money from the government and your employer. Treat it like an extra bit of income, just delayed until retirement.

Under auto-enrolment, you contribute a minimum of 4% of your qualifying earnings (which are earnings between £6,240 and £50,270 for this tax year), the Government adds 1% via tax relief and your employer tops this up with another 3% – so in effect your net contribution is doubled from 4% to 8%. 

There might be more on offer as many employers put in more than the minimum, some paying up to 12% of your income or matching the amount that you put in. Even more reason to use the scheme. 

But not everyone has access to a workplace pension. If you’re one of the 4.39 million self-employed people in the UK, your options are a self-invested personal pension (Sipp) or an ISA. And if you’re under 40, then you can access a Lifetime ISA too (which might be useful if you’re still to purchase a first home). 

For the purposes of this article, let’s look at a pure comparison between the tax benefits of ISA and pension. Lots of people choose to partly fill both allowances. But in some cases, it might be worth focussing on one over the other.

ISAs vs pensions

ISAs and pensions are both ‘tax wrappers’. That means they both allow the money held inside to grow free of taxes on any interest earned or capital growth on the investments. 

This is important because annual allowances for investment income and gains have been reduced by governments in recent years. This tax year, if you held investments outside an ISA or pension, for example, in a General Investment Account, you can only receive £1,000 in dividend income and £3,000 in capital gains before paying tax on the rest. It’s always better to invest using an ISA or a pension than outside one.

But, while the money held inside pensions and ISAs is treated the same while it’s growing over the long term, there are some crucial differences to be aware of.

Annual allowances

First, the annual allowances for putting money in are different. You can put up to £20,000 each tax year into an ISA. Most people don’t contribute anywhere near that amount – the average annual contribution in 2022 to 2023 (the latest data) was just £1,220.

You can put up to £60,000 a year into a pension, subject to your earnings being at least that amount. If you’re a very high earner then you’ll find the amount you can pay into a pension is restricted, but this only generally starts to happen once you start earning more than £200,000. That’s because the standard annual allowance of £60,000 reduces by £1 for every £2 of adjusted income you have above £260,000.

Pension tax relief benefits

One factor that makes many people focus on pension contributions over ISAs is the upfront tax relief that you get on the money that you pay into a pension. 

For every £80 that you pay into a pension scheme, HMRC adds another £20, topping it up to £100. If you’re a higher or additional rate taxpayer you can claim even more tax relief. Those who pay income tax at 40 per cent can claim an additional £20 and those who pay 45 per cent income tax can claim an extra £25 direct from HMRC. You’ll need to do this manually via a tax return each year.

The income tax relief on pensions gives the investments an instant boost, enabling your money to grow faster using the effect of compounding over the years.

Tax free withdrawals

ISAs by contrast don’t benefit from income tax relief on contributions. What you pay in stays the same amount once it’s in the wrapper. ISAs have an advantage at the other end though. Everything that you take out of an ISA either as income or profits is free of tax. In fact, you don’t even have to declare it on your tax return. 

With pensions, only the first 25 per cent of the fund that you take at retirement can be taken tax free. For most people, the maximum tax-free lump sum is set at £268,275. This is called the lump sum allowance (LSA). The rest is taxed as income. 

The upfront tax relief, and the compounding effect when it’s invested, plus the ability to take 25% tax free, all combine to mean your money could go a lot further when you choose a pension. And pensions work out especially well if you’re a higher rate taxpayer when contributing and a lower rate tax payer when taking a retirement income. 

Pension drawbacks

But there is a huge drawback to pensions in terms of accessing the money. With an ISA, you have complete flexibility and can take your money at any time, and for whatever reason. With a pension, you have to lock your money away until age 57, or, if you were born before 6 April 1971, until age 55 – and that’s only going to keep increasing.

If you’re a young adult looking ahead to big financial milestones such as perhaps a wedding, a house deposit, your children’s nursery, school or university costs, locking money away until your late 50s can feel difficult. Even if it feels like a rational decision, you may worry that life events such as redundancy or ill health may mean you need more flexibility. 

Which is best?

For this reason, many people choose to fill their pension as much as feels comfortable, while also making ISA contributions for the flexibility. The two wrappers complement each other well and there’s no harm in trying to use both as much as you can in your financial plans. In fact, sometimes, people move money from ISAs to pensions when they feel more comfortable about locking it away. 

In the end, please don’t procrastinate so much about making your choice between ISAs and pension that you don’t use the wrappers at all. Yes, it’s impossible to predict your life’s pattern of financial pressures. But even if you choose the ‘wrong’ mix of ISAs and pensions, you’ll likely be much better off than not using tax wrappers at all.