Individual savings accounts (ISAs) and pensions both offer efficient ways of saving for the future, but the money you invest in them is treated very differently by HMRC for tax purposes.
An individual savings account (ISA) is a way to reduce taxes on your savings and investments. They’re offered by banks, building societies, asset managers, National Savings & Investments and certain other financial institutions.
Any contributions you make to an ISA are made from net (post-tax) income, so you’ve already paid tax on the money. That means there’s no income tax to pay when you take money out of an ISA. Also, any gains your ISA makes are shielded from capital gains tax and income tax.
There are two main types of ISA:
You can mix these two types of assets in ISAs if you prefer, providing you don’t exceed the current £20,000 per year contribution limit across both ISAs.
There are also Junior ISAs, which can be either cash ISAs or stocks and shares ISAs and are held by parents / guardians on behalf of children under the age of 18.
Within these broad types of ISA are numerous different ISA options; which one is right for you will depend on your circumstances.
A pension is a way of saving for your retirement to fund you in old age once you’ve stopped working.
With pensions, you receive tax relief at your highest marginal rate on contributions. There’s also no tax to pay on gains your pension pot makes while it remains invested. However, depending on your financial circumstances when you begin drawing your pension, you may have pay income tax at this point.
For the purposes of this page, we’re discussing defined contribution pensions, also known as money purchase pensions. These are pensions where you save into a ‘pot’ throughout your working life and use this pot to generate a retirement income once you’ve stopped working.
Defined contribution pensions are the most common type of pension in the UK, especially since the introduction of auto-enrolment brought employer-sponsored defined contribution pension schemes to the masses by enrolling all eligible workers.
As well as employer-sponsored pension schemes, where both you and your employer typically pay into the pension a proportion of your wages, there are personal pensions which you can pay into yourself without an employer necessarily doing the same.
Here you may pay in from post-tax income and basic rate tax relief is applied, uplifting your contribution by 20%. If you’re a higher or additional rate taxpayer, you have to claim the additional tax back from HMRC in your tax return.
ISAs are an excellent way to save as any growth in your investments — either interest or returns on stocks and shares ISAs — is tax-free. The ISA limit for the 2023/24 tax year is £20,000 and you can invest this in either a cash ISA, a stocks and shares ISA, or a combination of the two.
You won’t have to pay income tax or capital gains tax on any of the returns you make from an ISA.
Pensions, on the other hand, are far more geared towards long-term saving as you won’t be able to touch the capital until you’re at least 55. You benefit from tax relief at your highest marginal rate if you invest into a pension — up to 45% — which you don’t get from an ISA. For a basic rate tax payer every £1 you put into a pension the government will make up 20p which gives you an immediate uplift of 20%.
IMPORTANT NOTICE 🧐
As of the Spring budget 2023, the UK chancellor announced the abolition of the pension lifetime allowance (LTA). This came into effect from 6 April 2023.
It’s important to note however, the Labour party has announced that if they were to be elected, the allowance may be reintroduced in the future. If this occurs, we will update our records to reflect any changes. The information on this page is based on the LTA pre 6 April 2023.
Below are some of the features of pensions and ISAs to provide a better idea of how they compare to each other. This is not intended to be financial advice on which to base your retirement planning decisions; it’s merely a comparison of two different savings vehicles.
Pensions | ISAs |
|---|---|
Receive tax relief at your highest marginal rate — see the below Pension Tax Relief Calculator to work this out | No income tax on profits from your investments |
Funds in a pension can grow free from capital gains tax | Funds in an ISA can grow free from capital gains tax |
You may have to pay income tax on pension withdrawals | No income tax is due on withdrawals from an ISA |
You can’t access your pension until you’re 55, unless there are highly exceptional circumstances | Most ISAs allow near-instant access, unless you’ve opted to lock away the funds for a set period to achieve a higher interest rate |
Maximum contribution into a pension is 100% of your earnings or £60,000, whichever is lower | Invest up to £20,000 per tax year into an ISA |
A lifetime allowance of £1,073,100 limits how much you can save into a pension in your lifetime without paying a 55% charge | No limit on how much you can save into an ISA in total, providing you don’t exceed the annual cap |
ISAs form part of your estate when you die and are subject to inheritance tax | Pension funds that remain invested under a pension wrapper are usually free from inheritance tax |
Depending on the type of pension you have, you may have access to a wide range of assets, including commercial property | ISA savings are predominantly held in cash or stocks and shares |
Cash ISAs rarely charge fees, but a stocks and shares ISA will likely levy charges such as an annual management charge or fees each time you buy or sell investments | Pensions may face a variety of fees and charges both in the accumulation phase (when you’re saving) a deculmulation phase (when you’re drawing benefits), although certain pensions, such as stakeholder pensions, limit these |
Workplace pensions offer contributions from your employer as well as your own contributions | From the 2015/16 tax year, if you pass on your ISA to your spouse it will retain its tax-free status, rather than losing it on the account owner’s death as previously. |
Generally speaking, pensions are best suited to long-term investment, and ISAs to short-term requirements. In an ideal world, you would be saving the maximum amount in both an ISA and a pension.
However, lots of people use ISAs as a way of saving for their retirement in a tax-efficient way, and plan to use their ISAs to supplement income in retirement. Both have their place — which one is right for you will depend on your needs and circumstances and ideally you’d have a conversation with an expert adviser before making any decisions.
A good financial plan can help you make the right decisions when it comes to your finances. Make the right decisions today to build a more prosperous future.
Good financial planning with clear goals can increase your retirement income by as much as 53%. Old Mutual Redefining Retirement Survey
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