Pensions versus ISAs: a beginner’s guide

We explain all the benefits of ISAs and pensions, including SIPPs. For those deciding between the two, we explain what to weigh up.  

If you have savings - whether you’re looking ahead to the next few years or down the decades to retirement – it makes sense to save as far as you can in a tax-free environment, so you don’t lose any growth in those savings to the taxman.

In the UK, we have two mainstream options to choose from: pensions and ISAs. Each has its own advantages and drawbacks, and lends itself particularly well to certain savings goals and situations, so this isn’t an ‘either/or’ choice.

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But you do need to understand the pros and cons of each to decide where to focus your attentions and how to allocate the spare cash that comes your way.

Pensions

If employees wanted to save into a workplace pension, they used to have to ‘opt in’ – and many didn’t bother. So, in a bid to boost regular saving for retirement across the workforce, the government rolled out its auto-enrolment scheme between 2012 and 2018.

Under auto-enrolment, all employers have to provide a pension scheme for their qualifying staff (those aged 22 and over, earning at least £10,000 in the 2020-21 tax year), and employees automatically become members unless they choose to opt out.

Auto-enrolled employees must contribute at least 5% of their salary each year into their pension and, importantly, employers must pay in a further 3% minimum. Some employers are more generous and will match staff contributions up to a certain limit.  

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So the chances are that you’re already a member of a workplace pension. Self-employed people and some with a workplace pension may also have a self-invested personal pension or SIPP, where they can manage their own pension, investing from a much wider range of funds, investment trusts and shares.

The single biggest attraction of pensions of any sort is that the tax benefits come upfront. You get full tax relief on all your contributions, with basic-rate tax automatically reclaimed and paid into your pension by your pension provider, while 40% or 45% taxpayers can reclaim another 20% or 25% through their tax returns.

Pensions therefore work particularly well for higher-rate taxpayers: they get more tax back, which effectively means they have to make smaller contributions than basic-rate taxpayers to end up with the same-sized pension pot.

However, all taxpayers with a pension have the advantage that right from the start, and possibly for the next 40 years or so, their money – and for workplace pensions their employer’s money too – is invested and growing gross of tax.

Over a long time frame, that extra money invested makes a massive difference, due to the power of compounding (whereby the returns on your capital themselves generate returns, and so on).

Pensions have other attractions

There’s a further tax advantage, in that your pension investment grows free of capital gains and income tax - a consideration that again becomes a much bigger deal over long time frames.

And importantly, you’re not allowed to withdraw the money in your pension pot until you’re 55 (57 from 2028). The restricted access aspect of pensions is often presented as a negative, but it can also be viewed as a great savings discipline: there’s no chance of you dipping in during the intervening years, so your retirement fund can grow uninterrupted.

When you do take money out of your pension, you’re allowed to take a valuable 25% free of tax, with income tax payable on the rest. But by that time you’re likely to be retired, and in many cases you’ll be in a lower tax bracket. Again, higher-rate earners stand to gain, as they received 40% tax relief but will only pay 20% income tax in retirement.

The pension freedoms introduced in 2015 mean there’s a lot of choice in how you access your pension – it is possible to withdraw part or all as cash, or move it into drawdown and take an income from your investment, or buy a lifetime income or annuity with it.

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Pension freedoms also allow you to leave any unused pension pot to your loved ones on your death; it does not count as part of your estate. If you die before reaching 75, it can be inherited completely tax-free; thereafter, the beneficiaries will pay income tax on it.

On the downside, there are limits to how much you can pay into this generous tax-beneficial environment. There’s a £40,000 annual limit on contributions across all your pensions in order to receive tax relief, and a lifetime limit also on the size of your pension pot, at just over £1.07 million this tax year, with a penalty charge on any excess.

Moreover, accessing your pension can be pretty complicated and there’s potential for a large tax bill if you’re not careful. The government guidance service Pension Wise (pensionwise.gov.uk) provides free help on the options at retirement. 

Another potential problem is that pensions are an obvious target for the cash-strapped Treasury to make savings in coming years. There has been plenty of speculation over the past couple of years that pension tax relief will be reformed and become less generous for higher earners.

ISAs

Since ISAs were introduced in 1999, there have been numerous changes to the rules. More recently, they have settled down somewhat.  

Everyone over the age of 18 (16 for cash ISAs) now has a £20,000 annual allowance (in the 2020/21 tax year). You can use it to hold a cash ISA (including a Help to Buy Isa, though these are no longer available to new investors), a stocks and shares ISA, an Innovative Finance ISA investing in less mainstream assets, or a Lifetime ISA. You can hold a mixture, so long as the total is within the £20,000 limit and you only put money into one of each kind of ISA in the same tax year. 

As far as tax is concerned, the savings or investments you hold in an ISA grow free of tax, as they do in a pension.

Unlike pensions, contributions into an ISA are out of taxed income and there’s no tax relief ‘up-front’, so you don’t get the benefit of your contributions being topped up by the government.

But instead, at the other end, all withdrawals are completely free of tax. That can be a valuable benefit, particularly in retirement when you might want to boost your income but avoid tipping over into a higher tax bracket.

In addition, ISAs have no time restrictions, so they are great if you’re saving for a goal - maybe a new car or school fees – in the next few years. Another key advantage is that ISAs are easy to access.

But you do need to be disciplined and resist taking money out unnecessarily if you’re saving for a goal.

Another difference is that, unlike pensions, your ISA will form part of your estate when you die. If your spouse or civil partner dies you can inherit their Isa savings and continue to enjoy tax-free growth on the contents.

Finally, it is worth having a quick look at the Lifetime ISA, which at first glance appears to be a kind of hybrid pension and ISA. Lifetime ISAs have some ISA advantages - tax-free income and gains at the end of your investment - but crucially they also get a chunky upfront top-up from the government, of £1 for every £4 you contribute.

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However, while this may sound a great option, Lifetime ISAs do come with some significant restrictions. For starters, you can only put up to £4,000 of your £20,000 annual ISA allowance into it, and you have to be aged between 18 and 40 to open one.

Most significantly, the upfront top-up is retained only if the money is withdrawn for one of three specific reasons: buying a first home; retirement at age 60 or over; or diagnosis of a terminal illness.

If you withdraw cash for any other reason, the government will take back 25% of the total fund: its original 20% top-up and capital growth, plus a 5% penalty.

Nonetheless, under-40s saving for a first home may favour a Lifetime ISA because of the government top-up and tax-free withdrawals.

How to decide whether an Isa or pension is best

Use a pension for…

• Saving for retirement (higher earners especially)
• Capitalising on your employer’s contribution
• Passing wealth to your children

Use an ISA for…

• School fees (tax-free income)
• Non-targeted savings (holidays, cars)
• Supplementary tax-free income or lump sums in retirement.