Pension vs. ISA: which is better?

Does a pension or an ISA offer the best way to successfully invest for retirement?

Pensions and ISAs are two of the most popular long-term savings vehicles in the UK. But while both can help you save for your future, they don’t quite do so in the same way. 

So, which one is ultimately best: pension or ISA? And how do you decide which one is right for you? Let’s find out.

Pension or ISA?

Before we get into the differences between the two and the debate over which is superior, let’s define each.

What is a pension?

A pension is a savings plan designed to help you save money for your later life or retirement. With a pension, you essentially save a portion of your earnings during your working life. This, in turn, will provide you with an income in later life or when you retire. Your money is usually locked until then.

Typically, the money in the pension is invested with the aim of increasing the amount you have to retire on.

One of the key benefits of a pension is that the government contributes too. This is usually in the form of tax relief.

At the moment, it’s likely a legal requirement to be enrolled in a pension by their employer (auto-enrolment). If you’re in this type of scheme, then your employer is also required to make a minimum contribution amount to your pension. 

What is an ISA?

An ISA is a tax-efficient savings and investment account. You don’t pay tax on any growth on your money or on any interest or dividends you receive from your ISA. 

Aside from retirement, you can use an ISA to save for a variety of other financial goals, including the purchase of a home, the purchase of a car or your children’s futures.

There are several different types of ISAs. These are:

  • Cash ISAs
  • Stocks and shares ISAs
  • Innovative finance ISAs
  • Lifetime ISAs

Unlike pensions, you can withdraw funds from most types of ISAs at any time. 

Every UK adult has an annual ISA allowance that they can put into an ISA. For the 2021/2022 tax year, the ISA allowance is £20,000.

What are the differences between pensions and ISAs?

The table below highlights the main differences between pensions and ISAs.

  Pension ISA
Accessibility Contributions made to a pension cannot be withdrawn until age 55 at the earliest. With an ISA, withdrawals can be made at any time unless it is a lifetime ISA. You can only withdraw from a lifetime ISA either to buy a first home or at the age of 60.
Tax Contributions to a pension are made before income tax is paid. Once you pay into a pension, you essentially get an income tax refund on that money. However, when withdrawing, only 25% of withdrawals are tax free. The remaining 75% of withdrawals are subject to tax.

Also, pensions don’t count as part of your estate and are therefore not liable to Inheritance Tax.

 

Contributions are made from your net income, which is income that you’ve already been taxed on. However, once the money is an ISA, it’s protected from income tax, dividend tax and capital gains tax.

Unlike pensions, ISAs are treated as part of your estate and are therefore liable to Inheritance Tax.

Annual allowance The maximum amount you can put into a pension each year and enjoy tax relief is £40,000. The maximum amount you can save in an ISA each year is £20,000.
Contributions If you have a workplace pension, then your employer will also contribute to your pension, as will the government in the form of tax relief. Most employers will pay the mandatory auto-enrolment minimum, but some will match your contribution (up to a certain limit). There are no extra contributions apart from those you make unless you have a lifetime ISA, wherein which case the government will top up whatever you contribute with a 25% bonus, up to a limit of £1,000 per year.
Investment options While a self-invested personal pension (SIPP) provides a wide range of investment opportunities, some employee pension schemes are limited in terms of where their capital can be invested. For example, they may only offer a small number of funds that do not fully capture an investor’s needs from either a risk or reward perspective. ISAs are very flexible and can be used to invest in a wide range of asset classes and geographies. With a stocks and shares ISA, for example, you can invest in individual stocks and shares, unit trusts, investment trusts, exchange-traded funds (ETFs) and OEICs. Check out our comparison of top-rated stocks and shares ISAs to learn more.

Who are pensions better suited for?

Generally, pensions may be better suited for:

  • Employed persons whose employers will match their contributions
  • People who don’t need to access their retirement savings until age 55
  • Higher-rate earners in general, because they can contribute up to £40,000 per tax year (versus £20,000 for an ISA). In addition, they will receive higher tax relief on their contributions.

Who are ISAs better suited for?

ISAs are likely to be better suited for:

  • People who enjoy the flexibility of the ISA or want the freedom to dip into their savings as and when they need to. This may be particularly relevant to people who are at the beginning of their careers and are unsure of their future financial position. Should they require capital to purchase a house or buy a car, for example, that money could be withdrawn from an ISA.
  • People who want greater control of what their money is invested in.

How do you decide whether to invest in a pension or an ISA?

Both a pension and an ISA offer a tax-efficient way to save for your future. But which one is better: pension or ISA? 

The answer is that it depends. Your needs, plans and circumstances will determine which one is better for you, so carefully assess your current situation. You can also seek professional advice if you are having difficulty making a decision.

Remember: there’s no rule that says you can’t have both a pension and an ISA.

In fact, a savings portfolio comprising both a pension and an ISA can provide you with the best of both worlds. You will be able to save for your future in a tax-efficient manner while still having access to a portion of your savings when you need it.