Pensions and ISAs have long been two of the most popular financial products for those looking to save money tax-efficiently. Both offer unique advantages and disadvantages, so understanding the benefits, rules, and your personal financial situation is key in deciding which is right for you – or how to best use them in combination.
According to Claire Exley, head of financial advice and guidance at Nutmeg, a digital wealth manager owned by J.P. Morgan, there are essential questions to consider when making this decision. As a starting point, Ms Exley suggested people think about their specific financial goals. She said: “Ask yourself two questions: What’s my goal? When will I need this money?”
Ms Exley said one of the key differences between ISAs and pensions is tax. She explained: “With ISAs, you pay tax on your contributions at the beginning, but withdrawals are usually tax-free. In contrast, pensions are taxed on withdrawals, but your contributions are boosted by tax relief.”
For many people, Ms Exley suggested that a combination of both ISAs and pensions can be beneficial.
When it comes to inheritance tax (IHT), ISAs and pensions are also treated differently, and the tax treatment can depend on the type of ISA or pension you have and who you’re leaving it to.
The Government announced in its October 2024 Budget that it is considering changing the treatment of pensions and IHT, but the details have not been confirmed. Ms Exley said, “If you’re unsure about the inheritance tax treatment of either an ISA or pension, it’s worth speaking to a financial adviser.”
If you have short-term money goals (1-3 years)
For short-term savings goals – such as a new kitchen or rainy-day fund – Ms Exley suggested a cash ISA or a regular savings account. She said: “A cash ISA allows you to earn interest without paying tax on that interest, up to a £20,000 annual limit. However, it’s important to be aware of withdrawal restrictions, particularly with fixed-rate ISAs.”
Ms Exley also recommended locking in a competitive interest rate on regular savings accounts. By doing so, you can take full advantage of your annual Personal Savings Allowance, which lets you earn tax-free interest up to a certain limit.
Basic-rate taxpayers can earn £1,000 in interest tax-free, while higher-rate taxpayers can earn £500, and additional-rate taxpayers have no allowance.
Ms Exley added: “Doing this can help you make the most of your annual Personal Savings Allowance without needing to use your annual ISA allowance.”
If your money goals are medium to long-term (3 years or more)
For those with medium to long-term financial goals, Ms Exley recommended considering a stocks and shares ISA. She said: “If you want to build wealth over three or more years and avoid capital gains tax, a stocks and shares ISA is a great way to invest.
“This type of ISA is tax-efficient as you don’t pay tax on dividends or any returns from the investments within the ISA.”
Ms Exley emphasised the importance of investing for the long term to maximise returns. She said: “As with all investing, it’s recommended that you invest your money in the ISA for at least three years, and you keep your money invested for as long as possible to maximise the potential of getting better returns.”
If you’re putting money away for retirement
When it comes to retirement savings, Ms Exley recommended contributing to a pension. She said: “It’s generally a good idea to start paying into a pension if you can.
“Once you retire, or even if you decide to work less, you’ll need income to live on, and the earlier you start planning, the better chance you’ll have of living the lifestyle you’d like to live in retirement.”
Explained the “rule of thumb”, Ms Exley said: “If you’re employed and putting money away for retirement, you’re likely to be better off paying into your workplace pension than an ISA.”
Workplace pensions often offer additional benefits, such as employer contributions and tax relief from the Government. “For instance, if you’re a basic-rate taxpayer and contribute £100 to your pension, you’ll only need to put in £80, and the government will top it up with £20 in tax relief.”
Higher and additional-rate taxpayers get 40% or 45% tax relief, respectively. The first 20% is added to the pension automatically, and people must claim the rest on a self-assessment tax return.
She also advised checking if your employer offers a salary sacrifice arrangement, which could reduce your tax bill and boost your pension contributions.
Self-employed individuals can still benefit from tax relief by contributing to a personal pension, while those with multiple pension pots could consider consolidating them for easier management.
Other options for saving – Lifetime ISA (LISA) and Junior ISAs
Ms Exley explained that the Lifetime ISA (LISA) is designed for individuals aged 18 to 39 to help them save for their first home or retirement.
She said: “You can contribute up to £4,000 each year and receive a 25% government bonus on your contributions (up to £1,000 a year).
“Like all ISAs, you won’t pay any tax on the interest you earn on cash or returns generated by investments. Withdrawals from a LISA to buy a first home or after you’ve turned 60 are free from tax, such as income tax.”
However, Ms Exley warned: “There are some strings attached that you should familiarise yourself with before going ahead.”
If you withdraw your money for any reason other than buying your first home or after you’ve turned 60, you’ll be charged a 25% Government penalty on the amount you take out. If you are using the money for a property, you must be a first-time buyer, and the house must be purchased for £450,000 or less.
So, it’s important to understand your goals, where you might be looking to buy a property and your timeframe before opting for a Lifetime ISA.
For those looking to save for children, Ms Exley recommended a Junior ISA (JISA). She said: “This is a straightforward, tax-free savings or investment account for children under 18. You can contribute up to £9,000 each year, and the child will have access to the funds once they turn 18.”
Ms Exley noted: “Some providers have different rules, but ultimately, the account holder pays no tax on interest, capital growth or dividends on any contributions. A child can have one cash JISA, one stocks and shares JISA, or both.”
