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Pension vs ISAs: which is better?

Should you have a pension or ISA (or both?)

Discover more in our handy pensions vs ISAs guide below.

Many people have built up sizeable pension pots in the hope that it will see them through retirement.

However, there are alternative savings vehicles available that could be considered, such as Individual Savings Accounts (ISAs).

There are many pros and cons of both investment types, so we will explore the significant differences and how they may affect you.

Learn more: ISAs vs savings accounts: which is better for you?

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Upfront tax relief

One of the main benefits of a pension vs an ISA is that you get income tax relief on any money you invest.

For example, if you are a basic rate taxpayer (20 per cent) and you want to add £1,000 to your pension, you would write a cheque for £800 and HMRC would add £200.

There is no tax relief available when putting money into an ISA.

So, although your ISA isn’t taxed, if you wanted to save £1,000 into your ISA you would have to write a cheque for £1,000.

Investment limits

Pensions have different limits regarding how much you can invest and still receive tax relief.

Each year you can contribute up to the “annual allowance” (which is currently £60,000).

If you have no UK earnings or earn less than £3,600 a year, you can still contribute up to £2,880 each year and get tax relief.

So, for example, if you have a salary of £60,000 you can add this full amount into a pension and get tax relief.

There is also a “lifetime allowance”, which caps the maximum value of your pension over your working life although this has recently been removed and will be abolished in April 2024. 

With ISAs there is only an annual contribution limit. This is £20,000 in total but you can split this over other types of ISAs. 

What happens when I retire?

With a pension you normally have to wait until age 55.

You can then take up to 25 per cent of your pension pot as a tax-free lump sum. The remainder is normally used to provide taxable income. 

There are many options available here including purchasing an annuity, which provides a guaranteed income for the remainder of your life.

You can cash from an ISA at any age. All withdrawals are completely tax-free and you can choose to make a big one-off withdrawal or a series of smaller withdrawals.

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What happens if I die?

If you die before drawing your benefits, your pension will normally pay out a tax-free lump sum.

For a company pension, this could be based on a multiple of your salary. For personal pensions, this could simply be the fund value on the day you die.

This value is normally not included as part of your estate, which is useful for anyone with an inheritance tax liability.

If you die after taking your pension benefits, the situation is very different and it fully depends on how you have taken your pension.

Your spouse may get a percentage of your pension (e.g. 50 per cent) or they may be able to take a taxed lump sum. In some cases they may get nothing.

ISAs are relatively simple: if you die, the entire ISA will be cashed in and paid to your spouse.

Bear in mind that when your spouse passes away this money can then be passed onto your children.

This isn’t always possible with pensions because many schemes only provide death benefits to your spouse.

So, is a pension or ISA best?

There are many benefits and drawbacks of both investment types.

Pensions have generous tax-relief upfront but you are then subject to numerous rules and restrictions about how and when you can take your money out. You are also taxed on most of the money you take back out.

ISAs are much simpler but you are held back by the lower annual investment limit.

In practice, a combination of ISAs and pensions will be suitable for most people. 

It is important to understand the ins-and-outs of any investment you choose so you know what to expect when you retire.

A financial adviser will be able to work out the right combination for your lifestyle and income.

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About the author
Nick Green is a financial journalist writing for Unbiased.co.uk, the site that has helped over 10 million people find financial, business and legal advice. Nick has been writing professionally on money and business topics for over 15 years, and has previously written for leading accountancy firms PKF and BDO.