Should you prioritise pension or ISA saving?

Faith Glasgow unpacks the difference between pension and ISA investing and which might be more suitable for you.

First things first: both ISAs and personal pensions such as SIPPs are simply tax wrappers that protect your money from the taxman, rather than investments themselves.

Within a stocks and shares ISA on an investment platform such as interactive investor, you can hold a vast choice of investments including stocks and shares, funds, investment trusts and bonds; the same is true of most SIPPs, although personal pensions from insurance companies typically offer a more limited range of investment options.

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So, the question we are looking at here is not about investment choice or performance; it’s about the tax conditions of each wrapper and which is best suited to your circumstances.

Tax-free growth

In both ISAs and pensions, your investment grows completely free of income or capital gains tax, so neither offers an inherent advantage.

Allowances

You can put up to £20,000 into an ISA each tax year; that can be split across a range of different types of ISA if you wish, but stocks and shares ISAs offer the most obvious comparison with personal pensions.

The annual contribution limit for pensions is considerably higher, at £40,000 – although if you have already started to take taxable income from a pension (not necessarily the one you’re contributing to), that limit is automatically cut to just £4,000.

There is also the lifetime pension allowance (LTA), fixed at £1,073,000 until 2026, to be aware of. That might sound like a very large sum, but it could potentially affect a broad swathe of investors: Royal London calculated in 2019 that more than a million people could be at risk of breaching it by retirement.

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Higher earners with large pension pots where investment growth could push above the LTA could be better off making use of their ISA allowances as a priority (and arguably also considering other tax-efficient investments such as venture capital trusts).

Tax on contributions and withdrawals

This is one of the key differences between the two wrappers. Any contributions you make into an ISA come from taxed income, and the tax break comes at the end of the investment: when you withdraw your cash down the line there is no further income or capital gains tax to pay.

In contrast, pension contributions get immediate tax relief, which boosts your pension pot. If you’re a basic-rate taxpayer you’ll automatically get an extra 20% boost on your contributions, meaning it only costs £80 to pay £100 into your pension.

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If you’re a higher-rate taxpayer, the rules are even more generous. Workplace pensions are usually topped up automatically by 40%, meaning it only costs £60 to pay £100 into your pension. In contrast, private pension contributions are boosted by 20% automatically and the remaining 20% is paid back as a tax rebate. You will need to fill in a tax return or write to HMRC setting out your pension contributions.

Even if you don’t earn at all or pay any tax, you can put up to £2,880 a year into a stakeholder pension and the government will give you an additional 20% relief to top it up to £3,600.

Better still, when you come to make use of your pension, you can take the first 25% tax-free; the remainder is taxable in the same way as other income, but you may well have moved into a lower tax bracket at retirement.

Pensions win out over ISAs for long-term investors, all other things being equal, because the up front tax relief means there’s more money actually invested across the decades.

To put that into context, a monthly contribution of £100 of taxed income into an ISA investment growing at 6% a year would be worth £98,000 after 30 years. In a pension, the £100 would be topped up to £125 a month for a basic-rate taxpayer and would have grown to £122,400 over that period.

They also make more sense for higher-rate taxpayers because the tax relief is a bigger deal. A higher-rate taxpayer making a £100 monthly contribution from taxed income would receive tax relief worth an extra £67 each month and their pot would be worth £163,500 after 30 years.

Accessibility

You can use an ISA in all sorts of situations because it’s very flexible. That means you can dip into your investment without restriction at any time you need it, although bear in mind that if you’re putting money into the stock market you should be thinking in terms of at least five years, and preferably longer.

Pensions are very different in this respect. They are designed to provide a source of retirement wealth, and therefore cannot be accessed before the age of 55, rising to 57 in 2028.

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Even after that, there is real danger in treating your pension pot as a handy windfall for special treats. If you dip into it in your 50s, you increase the risk that your money runs out before you do in the decades ahead.

Bearing that caveat in mind, your pension might be a useful ‘bridge’ if you lose your job or have to take time out as a carer after age 55 – but make sure you only take the 25% tax-free cash if possible. If you take taxable income, your scope for topping it up once you return to work will be limited, as the annual allowance falls to £4,000 a year.

Generally, if you’re investing towards a medium-term goal or for the occasional treat, an ISA is the obvious choice.

However, older (50-plus) investors - especially higher-rate taxpayers – could give their investments an instant boost by focusing on their pension for the up front tax relief, on the grounds that they are approaching (or have reached) pension access age and will soon be able to withdraw some tax-free cash if required.

Inheritability

For anyone concerned about the value of their estate but still in a position to contribute to either pension or ISA, a pension is generally more attractive because most fall outside their estate and therefore won’t count towards any potential inheritance tax liability. You can simply nominate who you’d like to inherit the pension and let your provider know.

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ISAs, in contrast, are normally treated as part of the estate and may attract inheritance tax. However, a spouse can inherit their partner’s ISA savings through an Additional Permitted Subscription (APS), also known as an inherited ISA allowance. Any ISA funds transferred as an APS keep their tax-free status and count as a one-off additional ISA allowance for the surviving spouse.

What’s best at a time of uncertainty?

Where does all this leave investors keen to do the sensible thing in the current climate of roaring inflation, recession worries and potential job losses?

In an ideal world, it’s a good idea to use both ISA and pension allowances, drawing on the ISA for pre-retirement financial goals and building the pension for later life. But if you are seriously worried about possible financial problems in the coming year or two, the priority should be building a tax-free cash cushion.

One option is to make regular or lump sum ISA contributions, but keep them in the cash holding area, ready to invest once you feel more secure. You could drip feed a portion into your investments each month if you can afford to, but make sure you retain enough ready cash to see you through if things get difficult.

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Alternatively, if you want to make your money work harder, look for a top-paying easy access cash ISA and build your contributions there. You can transfer the money across to a stocks and shares ISA without losing its tax-free status at a later date. (Bear in mind that if you want to transfer the current year’s contributions, you’ll need to move the whole balance – you can’t move just part, as you can with contributions from previous years.)