Pensions vs ISAs: Which is more Tax efficient?

Navigating the world of financial planning can be complex. A common question we encounter from clients looking to optimise their long-term savings is, “Should I invest in a Pension or an ISA?”. The answer isn’t straightforward, but understanding the tax implications can provide clarity. Sadly, there is no ‘Silver Bullet’ and several factors need to be considered. It is worth looking at these in turn to illustrate the point.

The Tax Advantages of Pensions over ISAs

A key advantage of pensions over ISAs in terms of taxation is the substantial investment incentive they offer. For instance, consider a personal pension where a £100 contribution receives £25 in tax relief from HMRC, bolstering the savings. This injection provides a significant boost to the savings. 

This £25 signifies the basic rate tax relief, and those subject to higher tax rates can gain additional relief through their tax return or an adjustment to their tax code. The same tax benefits apply to individuals in employer-based pension schemes, although the relief process may differ. For low earners in employer-based pension schemes, there may be no tax relief on contributions if the contribution is taken from income not subject to tax.   

In contrast, ISAs lack this advantage as contributions don’t enjoy any tax relief. Thus, the example £100 payment mentioned earlier wouldn’t receive an immediate £25 enhancement. 

Optimising Returns 

Both pensions and ISAs offer versatile investment options spanning cash savings accounts, stocks, shares, and specialised assets. Ultimately, a mix of these assets influences your chances of returns. Regularly assessing this mix is crucial to align it with your situation and expected returns.  

Notably, returns from chosen assets are tax-free within the plan for both pensions and ISAs, eliminating any tax burden on achieved returns. This is advantageous for investors using both products. 

Understanding Tax Implications

ISAs enjoy an advantage since withdrawals of income or capital remain tax-free. This is beneficial for those needing access to substantial funds.  

Compared to ISAs, pension rules offer flexibility for withdrawals, but complexity still exists. Generally, 25% of pension value is tax-free, while higher withdrawals incur income tax at the highest rate. This tax-free 25% can be taken gradually and combined with taxable portions. Considering these tax aspects, a comparison is made below for £10,000 payments with 3% growth over 5 years, assuming basic rate taxation for contributions and withdrawals: 

We can see from this chart, that from a purely tax perspective, the pension plan is more attractive.

Upon inspection, from a tax standpoint, the pension is more advantageous. This difference grows for higher-rate taxpayers on contributions and withdrawals. The pension offers tax relief on the full contribution, and tax applies only to 75% of the withdrawal – a powerful incentive. Pensions effectively defer tax, providing relief at investment and taxing 75% upon withdrawal. Higher-rate tax relief on contributions coupled with lower-rate withdrawal tax makes pensions a strong choice. 

Balancing Access and Contribution Restrictions

Considering the greater tax incentive of pension plans, it’s crucial to weigh and consider other aspects. Key points include: 

Access

ISAs grant flexible access to invested funds at any age. If flexibility is the most important aspect for you, then choosing the correct underlying investments for your ISA maintains this flexibility. 

Pensions differ significantly. Once invested, funds can’t be accessed by the investor until they reach pensionable age. Within the UK and for private pension plans, this is currently 55, rising to 57 in 2028. 

Restrictions on Contributions

ISAs allow up to £20,000 yearly per person as an annual contribution limit.

Personal pension contributions that can receive tax relief are limited to the greater of £3,600 or 100% of your UK relevant earnings. The total pension contributions from all sources are subject to a limit called the Annual Allowance, currently £60,000.

Tailoring Your Financial Strategy

As highlighted earlier, there’s no clear winner between pensions and ISAs. Your personal situation dictates the choice, considering tax status, contribution preferences, and access needs. 

For instance, a young individual saving for a home might not prefer a pension due to the restricted access until age 57. On the other hand, someone approaching retirement, transitioning from higher to basic rate tax, could benefit from the pension’s tax advantages. 

These are just two scenarios where one option might be superior. If uncertain, seeking financial advice is recommended. Our knowledgeable advisers assess your circumstances, listen to your goals, and recommend a suitable strategy. Contact us or call 01903 534587 our team of experts for more information.

The value of your investments in an ISA or Pension can go down as well as up, so you could get back less than you invested. Past performance is not a reliable indicator of future performance.

A pension is a long-term investment not normally accessible until age 55 (rising to 57 from April 2028 unless you have a protected pension age). The value of your investments can increase or decrease and therefore have an impact on the level of pension benefits available.

The information contained in this article is based on our understanding of legislation, whether proposed or in force, and market practice at the time of writing. Levels, bases and reliefs may be subject to change