Finding the right balance between tax-efficient pensions and ISAs

At a glance

• In the current environment, making the best use of tax-efficient wrappers such as pensions and ISAs is all the more important.
• Choosing between an ISA and a pension isn’t usually an either-or decision, because both are tax-efficient ways to save for your future goals.
• Pensions end up the most tax-efficient savings option, while ISAs are flexible and can be accessed at any time. Finding the right balance between the two will depend on your individual circumstances.

In his first Autumn Statement, Chancellor Jeremy Hunt announced reductions to a number of key tax allowances as part of his attempts to help the nation’s finances recover from a difficult few years.

With inflation still above 9%¹ and fiscal constraints still an issue, we’re unlikely to see significant changes in policy this spring, meaning the tax burden facing the UK public will remain a big concern.

So it’s all the more important to make the best use of tax-efficient wrappers such as pensions and ISAs to make your money work harder. But is one better than the other?

It’s not an either-or situation. Both pensions and ISAs are tax-efficient ways to save, but there are some key differences. Which one is right for you will depend on your individual circumstances, including where you are on your investment journey and your goals for the future. It may well end up that you use both to create the optimum mix.

Which is more tax-efficient: pensions or ISAs?

The tax benefits offered by ISAs and pensions make them a great way to save for your future. With both, you won’t pay Income Tax or Capital Gains Tax on any growth that you earn while your money is invested.

The key difference between ISAs and pensions is how the money going in and money coming out is taxed, as well as how and when you can take that money out. Pensions end up the most tax-efficient savings option, while ISAs are simple, flexible and can be accessed at any time.

Figuring out the right combination of savings vehicles isn’t always straightforward – you’ll need to think about income in retirement as well as estate planning, for example – so taking financial advice can make a real difference.

Pensions

A pension is the most tax-efficient vehicle available to UK savers, subject to certain limits, because the government typically adds relief to your contributions. This boost essentially increases the value of every pound you pay into a pension. If you’re a basic-rate taxpayer, for example, an £80 contribution into your pension becomes £100 through tax relief – an immediate 20% gain on your contribution. And for active members of workplace pension schemes, your employer also contributes at least 3% of their qualifying earnings.

You can contribute up to £40,000, or 100% of your earnings, in 2023/23 rising to £60,000 for the 2023/24 tax year, whichever is lower, each year, and access your pension pot from age 55 onwards, with this age set to rise to 57 in 2028. When you are ready to access your money, the first 25% can often be taken as a tax-free lump sum, with the rest taxed at your marginal rate.

You are also able to choose who receives your pension fund after you die, and pensions fall outside of your estate for Inheritance Tax planning.

ISAs

When you save into an ISA, you don’t receive tax relief on your contributions. But they do have other benefits, namely that there’s no age limit on when you’re allowed to access your money. This makes them more flexible – for example if you do need to cover any unexpected expenses. And, like pensions, the growth you earn isn’t subject to Income or Capital Gains Tax.

This tax year, you can put up to £20,000 into a Cash ISA or Stocks & Shares ISA. Your spouse or partner can also maximise their own ISA allowance. That could mean as much as £40,000 invested tax efficiently.

The differences and benefits of ISAs vs pensions

QuestionISAPensionCan I have instant access?

Yes

No access before age 55 (57 from 2028), with some exceptions

How much can I pay in?

£20,000 each tax year

Up to £40,000 for 2022/23 rising to £60,000 for 2023/24 tax year, or 100% of your earnings, whichever is lower

How much tax will I pay on it?

No Income or Capital Gains Tax on the growth

No Income or Capital Gains Tax on the growth; 25% tax-free lump sum at retirement, Income Tax payable at nominal rate on the remaining 75%

What tax relief is available on contributions?

None

20% available, higher/additional-rate taxpayers can claim further relief via self-assessment

What happens when I die?

Full value is included in your estate for IHT purposes

Pension funds not currently included in your estate for IHT purposes. Death benefits are tax free if paid before deceased's 75th birthday, but subject to beneficiary's marginal rate of tax if deceased was older than 75 at date of death

Can I carry forward my annual allowance?

No

You can use up any remaining unused annual allowance for the previous three tax years

Using a pension to reduce tax and reclaim allowances

Another advantage of pension contributions is that they can reduce your taxable income, which means you can avoid losing certain benefits and allowances – and have more money to save or spend. Payments into an ISA don’t provide these potential benefits, as they come from your taxed income.

Here are a few ways putting more money in your pension can reduce your taxable income:

●    Help you hold on to your personal allowance, which is slowly withdrawn once you earn more than £100,000.
●    Bring your income down below the additional-rate tax band, which starts at £150,000 and is being reduced to £125,140 after the 2022/23 tax year.
●    Help you hold on to your Child Benefit, which is gradually withdrawn if one parent in the household earns more than £50,000.

Options for income in retirement

The retirement income you take from a pension is taxable, whereas you can access funds from an ISA anytime without facing a tax charge.

You can take 25% of your pension fund tax-free from age 55, rising to 57 in 2028. Using that carefully together with the personal allowance means you can take your pension income tax-efficiently. And because pensioners typically pay lower Income Tax rates than they did while they were working, the tax relief gained when putting money into a pension is in many cases going to be more than the tax rate on the money taken out.

One final consideration is that most pensions are not subject to Inheritance Tax when you die. ISAs are subject to IHT, except when left to spouses or civil partners. So you’ll need to think about whether you want to prioritise income from your ISA savings to leave more of your pension benefits intact for your beneficiaries.

How to find the right balance of pensions and ISAs

Using pensions and ISAs together can help you save for the future as well as reduce your tax liability, contributing to overall financial wellness. The end of the tax year is an ideal time to take stock and ensure you’re making your money work as hard as possible, especially given the reductions in tax reliefs and allowances coming in 2023/4.

Because tax can be a tricky area, speaking to a financial adviser is the best way to take the pressure off and make sure you’re not missing out on potentially valuable tax benefits. We can match your plan to your short, medium and long-term goals, and manage all the niche rules and frequent changes – and not just at tax year-end.

No two people have exactly the same income, savings, assets and family set-up, so tax planning is a very personal thing. We’re on hand to create an individual, tailored strategy suited to you. Get in touch today.

The value of an investment with St. James's Place will be directly linked to the performance of the funds selected and may fall as well as rise. You may get back less than the amount invested.

An investment in a Stocks and Shares ISA will not provide the same security of capital associated with a Cash ISA.

The levels and bases of taxation, and reliefs from taxation, can change at any time and are generally dependent on individual circumstances.

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