ISAs vs Pensions for retirement

INTRODUCTION • THE BASICS • TAXES • FLEXIBILITY • CONTRIBUTION LIMITS • INVESTMENT OPTIONS • FAQs • CONCLUSION

Introduction

Choosing between an ISA and pension for retirement can feel overwhelming, especially if you're planning to retire early. Let's dive into the different tax treatments, access rules, and contribution limits.
The average retirement age in the UK is 64 for women and 65 for men, which, assuming you start working when you are 21, gives you around 43 years to prepare so it can be very tempting to get that new car or a new shiny thing. However neglecting investing for your future could leave you with some tough decisions as you reach pension age.

The Basics: ISA vs Pension Explained

An ISA (individual savings account) is a wrapper you can apply to investments which means when you want the money out, you don't have to pay a single penny to the tax man.
On the other hand, a pension is a different type of pot that can receive money directly from your salary before you pay tax and, depending on how you live and other factors, you might have to pay tax on part of it.

Tax Benefits Comparison

As above when withdrawing cash from an ISA there is no tax to pay. However all contributions must be made from your salary/income after tax.

A pension has a few other advantages that seem to incentive people to stay in the workforce. There are two types of pension I'll discuss here, they are a SIPP (Self invested personal pension) and a workplace pension.
In terms of the tax benefits they are very similar but require different amounts of effort. Like an ISA, SIPP contributions must be made after tax, however, you will automatically get a top up from the government giving you the 20% tax you paid before it made its way to your account. If you are in the 40% or 45% tax brackets, you need to apply to get the remaining refund via a self assessment.
If you are using a workplace pension, the contributions are made before tax so you get the full amount of tax relief irrespective of which tax band you are in.

After reaching retirement age, you are able to withdraw 25% of the value of your pension tax free, this is usually to finish off a mortgage but you're free to blow it all on a yacht if that floats your boat. The remaining 75% will be taxed at your marginal rate.

The way I see the difference is pay tax now (ISA) or tax later (pension). So if you think taxes will get better defer using a pension, if you think they'll get worse, use an ISA. Personally, I can't see any politicians being able to lower taxes.

Access and Flexibility

Access is another crucial point to consider. An ISA can be accessed at any age whereas with a pension, you will have to wait until you are at least 55 (although that age is already scheduled to increase and there is nothing to indicate that it will stop increasing anytime soon). If you are planning to retire before you can access a pension, you will need to make provisions to tide you over from stopping work till you can access your pension. If you want to know more about retiring early, take a look at this article.

Annual Contributions and Limits

Unfortunately, there are limits on how much can be contributed to both ISAs and pensions in a year Fortunately these limits are fairly generous so if you can hit the limits and still live your life, you'll likely be in a very good financial position.

The limit for all ISA contributions combined, for anyone over the age of 18, is £20,000 per year. For a Junior ISA, it is £9,000 per year. If you want to see more about the different types of ISA check out this article. There is no limit on the total amount you can hold in an ISA.

The annual allowance for a pension is much higher at either £60,000 or 100% of your income, whichever is lower. There used to be a lifetime allowance which was the maximum amount you can have in a pension before incurring extra changes, this was most recently set at £1,073,100 but that has since been abolished and there is no cap on the amount you can have in a pension.

Investment Options

There are many providers for both pensions and ISAs but they (for the most part) have fees, whether it's a management fee, transaction fee or a government tax.
The government taxes I've experienced only apply to buying stocks outside of a fund. The UK Government charges a 0.5% tax on any individual shares you buy.
If you decide to buy shares in a company listed in the US, there is a withholding tax of 15% on any dividends paid to UK investors.

For an ISA, you can primarily invest in companies that are publicly listed on any stock exchange whether that's the S&P500 in America or the London Stock Exchange here in the UK. If you want some exposure to cryptocurrencies, commodities or property, you might consider buying shares in companies that work with them. For example Strategy (formerly MicroStrategy) for bitcoin, Rio Tinto for mining and a REIT (Real Estate Investment Trust) or house builder for property.

For a pension, it is possible to buy the same things as you can in an ISA but some providers may offer packages containing investments that are not available to individual investors.

FAQ's

Can I transfer money from a pension to an ISA?
No, a pension and an ISA are totally separate so money or investments cannot be transferred between them. You can however transfer from one ISA to another and one pension provider to another.

What happens to my ISA if I move abroad?
If you move abroad and become a non-UK resident, you generally cannot put any more money into it.
However, you can keep your ISA open and you’ll still get UK tax relief on money and investments held in it. If you return to the UK and become a resident you will be able to pay into your ISA again.

Can I have multiple ISAs and pensions?
Yes, there is no limit on the number of ISAs and pensions an individual can hold. Just remember the deposit limits from earlier apply to the total of the accounts. Also the more accounts you have, the more complex it will become to keep track of them all.

What if I change my mind, can I stop pension contributions?
Yes, By default, if you are over 22 and below the state pension age, earn at least £10,000 per year and you usually work in the UK, you will contribute 5% of your salary and your employer 3%. If you do not want to do this, you are free to stop those contributions by talking to your employer.

Do ISAs affect benefits or state pension?
ISAs effect benefits but not your state pension. When the government assess your entitlement to Universal Credit, they take ISAs into account. There is no means testing for the state pension and there is currently no link between the state pension and an ISA.

What happens to my ISA when I die?
If you die with an ISA, your provider can be instructed to sell the investments and pay the proceeds to the administrator or beneficiary of your estate or transfer the investments to your surviving spouse’s or civil partner’s ISA - this is only possible if they have the same ISA provider as you.
There are 3 ways an ISA will close when you die:

1. Your executor closes it

2. The administration of your estate is completed

3. Your ISA provider will close your ISA 3 years and 1 day after you die.

Conclusion

The decision between ISAs and pensions depends on your specific situation, but there's a logical order to consider your options.
First, if your employer offers pension matching, contribute enough to get the full match, it's genuinely free money that beats any other consideration.
Next, ask yourself when you want to retire. If you're planning to retire before age 55, prioritize ISAs since you'll need accessible funds and can't touch pension money until then.
If you're retiring after 55 and you're a higher rate taxpayer, pensions typically make more sense due to the significant tax relief at 40% or 45%.
For basic rate taxpayers, ISAs have a slight edge due to their flexibility, though the tax advantage is smaller. If you are fortunate enough to be able to afford to max out both the £20,000 ISA allowance and your pension contributions, use both equally to diversify your tax treatment.

As an aside:

A good way to use a pension is to pay just enough for you to drop down a tax bracket so you get the higher tax relief and only pay the lower rate of tax on the salary you want to keep. For example, If you have a salary of £55,000/year, you could opt to pay £4730/year into your pension taking your salary to £50,270/year. this would move you from the 40% tax bracket to the 20% tax bracket.

Your view on future tax rates also matters - if you think taxes will rise, pay them now through ISAs; if you think they'll fall, defer them through pensions. For most people pursuing early retirement, the answer isn't either-or but rather which to prioritize based on these factors.

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Disclaimer

The usual disclaimer: I'm just a guy on the internet sharing what I've learned. This isn't financial advice so do your own research and speak to a qualified adviser about your specific situation.