Pensions vs. ISAs in brief
An ISA is a product that allows you to save money without paying tax on the interest you receive. In the 2022/23 tax year, the maximum amount you can save in an ISA is £20,000. You can usually withdraw the money as and when you need it.
A pension is a product for saving specifically for retirement, so you won’t be able to access it until you’re a certain age (currently 55), apart from in very rare situations. One of the key benefits of saving into a pension is that the government contributes too, in the form of generous tax relief.
Deciding whether to pay into a pension or an ISA
When you’re deciding whether to put money into a pension or an ISA, you need to take your individual situation into account, including your age, when you’re likely to need access to the money, and your tax relief entitlement. Also remember that if you’ve got a workplace pension, your employer is likely to make contributions too, which could considerably boost your savings.
For many people, it makes sense to pay money into both an ISA and a pension, as you may be keen to enjoy the tax benefits of a pension but need some money that’s accessible now. Here’s a summary of some of the main features of each product.
When you put money into a pension, you get an income tax refund on that money. You get 25% tax top ups on contributions that you make, and higher and additional rate taxpayers can claim a further 25% and 31% respectively through their Self-Assessment tax returns. This means that for a basic rate taxpayer, the government effectively adds £25 for every £100 you pay into your pension.
The maximum amount you can save into a pension annually and receive tax relief is currently 100% of your salary, up to a maximum of £40,000. When you retire and take money from your pension, however, you’ll have to pay income tax, apart from the initial 25%, which you can take tax-free.
You don’t get a tax refund when you pay into an ISA, but your investment is protected from tax, so you don’t pay any tax on the interest you earn.
Under new rules, you get a personal savings allowance (PSA) anyway, so basic rate taxpayers can earn up to £1,000 of interest a year without being taxed on it, and higher rate taxpayers can earn up to £500 without paying tax. Interest you earn from an ISA doesn’t count towards this allowance, so it keeps your PSA intact.
Investments and returns
Balanced pension funds are usually invested in a range of assets, which is a way of managing risk. The money you put in a pension may be invested in a mix of shares, bonds, property and cash, for example. Pension funds fluctuate as they’re affected by market volatility, but as you’re investing for the long-term, highs and lows are often balanced out.
It’s impossible to predict how your pension fund will perform, but pension calculators sometimes use a figure of 4% or 5% growth (before inflation is taken into account), to make projections.
In terms of ISAs, there are different types available. Cash ISAs are just tax-friendly savings accounts. There are also stocks and shares ISAs, which allow you to invest in funds, bonds and shares in companies. Stocks and shares ISAs are usually more appropriate for long-term saving than short-term saving. Historically, in the long run stocks and shares have brought better returns than savings accounts, but that’s not a guarantee that they’ll do so in future.
There’s also a new Innovative Finance ISA, which means you can get tax free interest on peer-to-peer lending. This investment model can be risky, but some Innovative Finance ISAs are offering estimated returns of up to 6%. Innovative Finance ISAs are often not covered by the Financial Services Compensation Scheme.
You can only access your pension money when you reach 55, and this age will increase to 57 in 2028. When you’re 55, you’ve got quite a few options. You can take up to 25% as a lump sum tax free, you can leave your money invested and take cash sums out when you need them (via ‘drawdown’), and you can buy an annuity (a guaranteed income). Find out more on our page about cashing in your pension.
You can usually take money from your ISA whenever you want, although your options will depend on the type of ISA you’ve got and any restrictions that the provider places on the product. Pay close attention to the tax rules when you’re withdrawing money from your ISA though.
If you die before 75 and you’ve got a defined contribution pension, your pension is held outside of your estate and can be passed on to your beneficiaries tax-free. If you die after the age of 75, your beneficiaries will have to pay tax at their marginal rate of income tax on any pension that you’ve left them. You can find out more in our article about passing on your pension when you die.
Your ISA savings are counted as part of your estate, so they’ll be added to your other savings and assets when you die and your beneficiaries may have to pay inheritance tax. Inheritance tax is due on estates worth over £325,000 and is charged at 40%, but it doesn’t apply if you’re passing your money on to your spouse or civil partner.
Previously, your ISA always lost its tax-free status when it was inherited, but under new rules you can pass your ISA on to your spouse or civil partner and it’ll retain its tax benefits, giving your partner a temporary additional allowance.
This article is simply intended to summarise some of the features of ISAs and pensions and does not constitute financial advice. If you need help with investment decisions, speak to an independent financial adviser.
Last edited: 21-03-2022