With all the different contribution, withdrawal and taxation rules, it can be daunting to work out where to save and invest. We hope this page helps you find an allocation that works for your circumstances.
Pensions vs ISAs
Money going in to a pension receives tax relief, meaning you do not pay income tax on it.
This makes it very cost effective to contribute to a pension – you get more inside your pension than you would in your pocket if you’d chosen to take it as pay. When you retire and take an income from your pension, you do pay income tax on money you withdraw from your pension.
In contrast, money going into an ISA is considered to have been taxed already, because you pay into an ISA from your net pay – you’ve already paid income tax on the money. You do not pay income tax on money withdrawn from an ISA.
All other things being equal, these two approaches would work out exactly the same. If your income tax was a consistent %, it wouldn’t make any difference whether it’s taken out at the start or end of the process.
However, in reality there are more factors which affect the rates at which you are taxed, and make pensions more financially efficient for building wealth – with the limitation of course that they cannot be accessed until age 55+.
A detailed analysis can be found on this Monevator article, but in summary:
- If you have not yet maxed out your employer’s contributions to your pension scheme, do so – this is essentially free money/extra salary which can only be accessed by saving it in to a pension, do not turn it down.
- If you are a higher rate taxpayer or above, the tax relief on your contributions is likely to be worth more than the tax you will pay in retirement. For example you could receive 40% tax relief on the way in, but pay only 20% tax on the way out.
- If you pay into your pension scheme via ‘salary sacrifice’, you will avoid National Insurance Contributions of 12% on pension contributions in addition to the 20% tax relief, so again you end up ahead.
- When you withdraw money from your pension, 25% of it is tax free, and income tax is only paid on the remaining 75%. You also have a personal allowance which means you do not have to pay income tax on the first £12,500 of income you receive per year (the same as you do when earning). So even as a basic rate taxpayer with maxed out employer contributions and no salary sacrifice, pensions give you a tax discount compared to ISAs.
As you can see, from a purely financial point of view, for most people pensions will be more tax-efficient. But this advantage has to be weighed against their access age limitations.
Calculating how much to contribute to your pension and ISA
The deciding factor is generally when you think you’ll want to be able to use your savings. If you know you’ll definitely need the money sooner than you can access your pension, there’s no difficulty in deciding to save in an ISA. And conversely, if you know for sure you won’t need it until aged 55+, you can use your pension without worry.
But of course none of us are able to predict the future with absolute certainty, so it comes down to an assessment of your individual situation, goals, and preferences.
A good start would be to visit our pensions page to calculate what retirement income you can expect at your current level of pension contributions. It’s important to ensure that you’re on track for a pension income that is acceptable to you.
For any additional long term savings, it’s worth taking the time to calculate just how much the pension tax advantages are worth in your specific situation – putting a number on it may help you make a decision.
If you’re still uncertain, it’s important to understand that without the benefit of hindsight you can’t guarantee an ‘optimal’ choice. Instead think about whether you would prefer to err on the side of contributing more to your pension (maximising your money’s ability to support you at age 55+, but at the cost of locking funds away inaccessibly should your plans change) or if you would prefer to lean towards your ISAs (keeping money accessible at any age, but potentially having to save for longer to reach the same amount of future income).
Pensions vs Lifetime ISAs
Lifetime ISAs were designed to be a hybrid savings vehicle – save up for your deposit, then save up for retirement. However in reality a pension almost always works out to be more cost-effective for retirement savings.
The 25% LISA bonus is equivalent to 20% pension tax relief
It’s a common (and very understandable) mistake for people to assume that the 25% bonus is higher – but in fact it’s the same money looked at from another direction.
For £1000 of money earned:
- Contributed directly to pension: £1000 in pension.
- Contributed to a LISA: £200 income tax paid, leaving £800. Put in a LISA, receiving a 25% ‘bonus’ of £200, taking it to £1000.
The percentages look different because the same £200 is being compared to the gross pay (£1000, so 20%) and to the net pay (£800, so 25%).
The appealing thing about the LISA is that it is also tax-free when you withdraw it, while with a pension, you have to pay some income tax when taking income from it.
Differences between pension and LISA (for retirement)
There are no employer contributions available for LISAs. You should always max out your employer contributions.
The LISA bonus is fixed regardless of your tax situation. If you are a higher or additional rate taxpayer, the LISA bonus will be lower than your pension tax relief.
Even if you are a basic rate tax payer, if you pay in to your pension via Salary Sacrifice, you will avoid National Insurance Contributions of 12% on pension contributions in addition to the 20% tax relief, so again the pension ends up ahead.
However, when you withdraw money from a LISA, you do not need to pay any income tax. When you withdraw money from a pension, you get 25% of it tax-free, and the remaining 75% is taxed as income.
So in summary, if (and only if):
- You are already maxing out employer pension contributions
- You are a basic rate taxpayer
- You don’t have access to a salary sacrifice scheme
Then yes, a LISA is more cost effective for you, as you will pay £0 income tax on withdrawals.
Pension vs ISA vs LISA comparison table
|Pension||Stocks & Shares ISA||LISA|
|Annual savings limit||Lower of £40,000 or annual salary*||£20,000||£4,000|
|Lifetime limit||£1.03 million (planned to rise with inflation)*||None||None|
|Tax relief on contributions||Highest marginal rate (20%, 40%, 45%) up to annual limit*||None||25% bonus (max £1,000 per year), equivalent to 20% rate relief.|
|Tax on investment growth and dividends||Tax-free||Tax-free||Tax-free|
|Tax on withdrawal||25% tax-free, remainder subject to income tax||Tax-free||Tax-free|
|When the funds can be taken out||After age 55 (this is due to rise)||Any time||Age 60, or earlier with a penalty.|
|Treatment for means-tested benefits||Not assessed unless available, and even then are assessed as income only||Considered when assessing benefit applications, may need to be spent down||Considered when assessing benefit applications, may need to be spent down|
|Death treatment||100% tax free if death before 75, liable to income tax on recipient if death after 75*||Can’t be inherited in-situ, forms part of deceased’s estate||Can’t be inherited in-situ, forms part of deceased’s estate|
|*The treatment is actually far more complicated, but for most people this is correct.|
Why timing of tax relief doesn’t matter
A common misconception is that getting your tax relief at the start of the process is more effective than at the end because the money has time to compound.
In fact the timing of tax relief makes no difference. If we look at £1000 of savings:
- Pension: you put £1000 in your pension. Over the years the investment grows ten-fold giving £10,000. If taxed at 20%, £8000 remains.
- ISA: after paying income tax you have £800 to invest in your ISA. Over the years the investment grows ten-fold leaving you with £8000.
What makes a difference is the differences in the rates of taxation, such as getting 40% tax relief but paying 20% income tax on withdrawal, paying lower National Insurance using salary sacrifice, and the 25% discount for withdrawals from a pension.
Treatment for means-tested benefits
Money in an ISA or LISA might need to be spent down before you are eligible for certain means-tested benefits. Money in a pension is not counted at all if you are too young to access it, and even after you are able to access your pension, you are assessed based on the income it provides, not on the full capital. For more information see this page from EntitledTo for under 60s, and this page for over 60s.
Treatment on death
ISAs, including LISAs, are treated as estate assets on death, and could be liable to inheritance tax. They would also need to be liquidated and passed on as cash.
Pensions have very attractive treatment on death, with no tax payable by the recipient whatsoever if death occurs before age 75, and taxed as income on the recipient after 75. Pension benefits are not ordinarily included in estate assets and so shouldn’t attract inheritance tax.