Pension vs ISAs: which is better?

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

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?

What is 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%) and you want to add £1,000 to your pension, you would contribute £800 yourself and HMRC would add an additional £200 in tax relief.

On the other hand, there is no upfront tax relief available when putting money into an ISA.

Instead the benefit comes from tax-free growth on investments and withdrawals. This means if you wanted to save £1,000 into your ISA, you would have to directly contribute the full £1,000.

What are the 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 or 100% of annual earnings). This tax relief limit applies to total contributions from the individual and their employer.

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 which would take this up to £3,600. 

Previously, there was a ‘lifetime allowance,’ the maximum amount you could build up in your pensions without paying extra tax. 

However, this has now been abolished, meaning there is no longer an upper limit on the total value of pensions you can accumulate without facing additional tax charges.

Other controls like the annual allowance mentioned above still apply, as well as the tapered annual allowance if you’re a high earner. 

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 such as cash, stock and shares, innovative finance and lifetime ISAs.  

It’s worth flagging some ISAs, such as the lifetime ISA and junior ISA, have different annual allowances.

What about employer contributions?

Perhaps the biggest difference between pensions and ISAs is that a pension is usually set up by your employer. You’ll also benefit from employer pension contributions, which can give your wealth a big boost over time.

It is also possible to set up a personal pension, which can be a great option if you are self employed or want to top up your workplace pension.

In contrast, ISAs are completely separate from your workplace and can only be set up by individuals. This means you won’t receive any additional employers’ contributions to your ISA - it’s all down to you.

What happens when you retire in the UK?

With a pension, you normally have to wait until age 55 to access it, although this is due to rise to 57 in 2028 within the UK.

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

Many options are available, including purchasing an annuity, which provides a guaranteed income for the remainder of your life or a specific period, or using a drawdown instead. 

You can withdraw cash from an ISA at any age, but whether you can pay it back in within the same year without affecting your annual allowance depends on whether it’s a flexible ISA. 

All withdrawals are completely tax-free, and you can choose to make a big one-off withdrawal or a series of smaller ones which can help with both short-term savings and longer term retirement planning.

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 different, depending on how you have taken your pension. Your spouse may get a percentage of your pension, or they may be able to take a taxed lump sum.

If you die after age 75, any lump sum or income taken will be subject to income tax at the beneficiary's marginal rate, and if it exceeds the lump sum death benefit allowance (LSDBA), a 45% tax rate will apply to the excess. 

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

Bear in mind when your spouse passes away, this money can then be passed onto your children. This isn’t always possible with pensions, as 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.

Both ISAs and pensions provide a cosy tax wrapper to protect your wealth from capital gains tax, dividend tax and income tax on interest. This means you won’t have to pay tax on gains, dividend income or interest payments inside your pension or ISA.

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.

Pensions are particularly beneficial for higher-rate taxpayers who get a higher rate of tax relief on initial contributions.

ISAs are much simpler and more flexible, 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.

Get expert financial advice

Ultimately, the choice between pensions and ISAs depends on your financial goals, tax situation, and flexibility needs.

Pensions offer attractive tax relief on contributions but come with restrictions on access and taxable withdrawals. ISAs provide more flexibility with tax-free withdrawals but have lower annual contribution limits.

For most people, a balanced approach using both options can offer a blend of tax efficiency and accessibility, helping you build a robust retirement plan that suits your individual needs.

Let Unbiased quickly match you with a financial adviser for expert financial advice on choosing between a pension and an ISA to determine which option better suits your financial needs and retirement plans.