Is an ISA a better investment than a pension?
Pensions and ISAs are both tax-efficient ways to save. Knowing how they compare is key to using each most effectively.
Pensions and ISAs are both tax-efficient savings vehicles, with generous savings allowances, which make them ideal for big, long-term, financial goals.
However, there are significant differences between the two products, most notably in terms of access and tax. Here we explain how pensions and ISAs work to explore the role both can play in helping you achieve your long-term financial goals.
What is a pension?
Pensions are designed purely for retirement saving and have special features that encourage us to save. In addition to tax-free growth, savers also get tax relief on pension contributions. In simple terms, this provides savers with a rebate, equivalent to their rate of tax, to top up their pension. That means it only costs a basic rate taxpayer £80 to invest £100, a higher rate taxpayer £60 and an additional rate taxpayer just £55.
If it’s a workplace scheme, you get the benefit of employer contributions too.
However, in return for these incentives you won’t be able to access your money until you approach retirement. At the moment, you can start accessing your pension as soon as you turn 55, but from 2028 that age will rise to 57.
Each year you can invest 100% of your income into a pension, subject to an overall cap of £40,000. This is known as your annual allowance.
» COMPARE: Personal pension providers
What is an ISA?
ISAs are considered all-purpose savings vehicles. You can use them to save for retirement should you wish, or any other financial goal you might have.
ISAs also come with generous tax benefits to encourage us to save. Like pensions, savings in an ISA will grow tax free, but you won’t get tax relief on contributions. Instead, when you take your savings out of your ISA, that money won’t be subject to income or capital gains tax.
You don’t have to tie your money up with an ISA either, and can dip into it whenever you need to.
Each year you can invest £20,000 into an ISA, this is known as the ISA allowance.
Confusingly there are several types of ISA. These are:
You can spread your £20,000 allowance across the different types of ISAs each year if you’d like. It is also worth noting that you can only open one of each type of ISA in the same tax year.
When people talk about using ISAs instead of pensions or other long-term savings goals, they are usually referring to stocks and shares ISAs. This is because both will allow them to access stock market-based investments that are considered suitable for long-term saving. In fact, if you ran your accounts on an online investment platform, you could hold identical investments in a SIPP and a stocks and shares ISA.
» COMPARE: Self-invested-personal pension providers
Cash ISAs currently have low interest rates and for that reason they would not offer sufficient growth potential to rival a pension or stocks and shares ISA, while innovative finance ISAs - which allow you to invest your ISA allowance in peer-to-peer loans - are still considered a left-field option and remain untested over the long term.
Lifetime ISAs, which are structured to help people save for either a home purchase or later life could be considered but they are subject to different rules and have different allowances to other ISAs.
Pensions and ISAs compared
|Access||You cannot access a pension until you are 55 (rising to 57 in 2028)||You can access money in an ISA whenever you like (unless it is a fixed rate cash ISA)|
|Tax||Tax relief on pension contributions. Money grows tax free. When you access your pot, 25% can be taken as a tax free lump sum the rest is potentially taxable||Money grows tax free. No tax will be payable when you take money out of your ISA|
|Allowance||100% of your income up to £40,000 each year||£20,000 each year|
|Investment choice||Contributions can be invested in cash, bonds, shares and funds, with choice varying according to provider||Contributions can be invested in cash, bonds, shares and funds, with choice varying according to provider|
Is a pension or ISA best for me?
You can often get access to the same - or very similar - investments whether you are investing in a pension or an ISA. The product which works best for you will ultimately depend on your savings goal.
For retirement savings, a pension is usually best. In addition to the tax relief on contributions - which can have a massive impact on the eventual value of your pot over the decades - the fact that your money is tied up until you are 55 (57 from 2028) means you won’t be tempted to spend it on anything else. Although your pension income will be taxable, when you retire you may pay a lower rate of tax than you did in your working life.
» MORE: How to plan for retirement
ISAs by contrast may be better for other major savings goals. Investment allowances are generous, allowing you to build a big tax-free pot of cash and unlike a pension, you can access the money whenever you need it.
However, as most people will have a range of savings goals - including retirement - it usually makes sense to have both a pension and an ISA. You may also find it makes sense to put some later life savings into an ISA to keep your retirement income as tax efficient and flexible as possible. Taking some money from an ISA in retirement, for example, may mean you need to take less out of your pension and reduce the amount of income tax you pay on your overall income.
An experienced independent financial adviser (IFA) will be able to help you pick the right products for your savings goals and plan your retirement income as tax efficiently as possible. You can find one in your area at unbiased.co.uk.
WARNING: We cannot tell you if any form of investing is right for you. Depending on your choice of investment your capital can be at risk and you may get back less than originally paid in.
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Rachel Lacey is freelance journalist with 20 years experience. She specialises in personal finance and retirement planning and is passionate about simplifying money matters for all. Read more