Should I invest in an ISA or my pension?

At a glance

• ISAs and pensions both have their uses and tax advantages, but also their own risks.
• Workplace pensions offer both tax relief and employer contributions, while ISAs let you build an entirely tax-free savings pot.
• It’s always smart to have multiple means of saving for your post-work life.

Saving for retirement should be a top priority no matter your age, but the different options available can sometimes make it feel overwhelming.

Pensions are typically thought of as the go-to savings vehicle for retirement, offering a way to save throughout your working life while benefiting from things like tax relief and employer contributions.

Yet ISAs can also be used in this way, offering the chance to build a healthy tax-free savings pot, potentially with a Government bonus thanks to the Lifetime ISA.

But which one should you focus on? The option that’s right for you will depend on your short and long-term goals, so let’s take a closer look at whether you should invest in an ISA or a pension.

ISAs or pensions – which is best?

There’s no simple answer to this question as it all comes down to your circumstances, but here’s an overview of things to consider with each option:

Types of pension

If you’re focusing on pension saving, it’s important to think about which type of pension you want. There are several to consider, broadly broken down into workplace and private pensions: workplace pensions should be seen as vital for anyone in employment thanks to employer contributions, but private pensions (such as SIPPs) can be a valuable addition, or even an alternative for those who are self-employed.

Our ultimate guide to pensions provides a full explanation of the types available and the benefits of saving.

Types of ISA

There are different types of ISA to consider as well, with the basic choice between cash or stocks & shares ISAs. The former offers zero investment risk to your money but smaller returns (and here you can choose between variable or fixed rate accounts), while the latter offers the potential for much higher returns but your capital will be at risk.

Stocks & shares ISAs are typically seen as being more suitable for long-term saving as there’s plenty of time to weather any dips in stock market performance, but it’s always recommended to consult a financial adviser before making your decision. Then there’s the Lifetime ISA to consider, which we’ll cover in more detail below.

Investment limits

It’s important to remember the investment limits associated with each option, as breaching them could mean you’re subject to additional tax.

Pensions have an annual contribution limit of £60,000 (or your annual income, whichever is lower) if you want to benefit from Government tax relief, though note that this allowance is tapered for higher earners. You can still pay in more than this, but you won’t receive tax relief on the contributions, and you may have to pay tax on the additional amount.

ISAs have an annual tax-free allowance of £20,000, which applies to both cash and stocks and shares versions regardless of your income. The only exception to this is Lifetime ISAs, which have a lower limit of £4,000.

Investment risk

There’s investment risk to consider too, particularly when it comes to pensions – returns are dependent on the performance of the stock market, and so your pot has the capacity to fall as well as rise in value. You can normally choose lower-risk funds according to your attitude towards risk, but even with these there is the possibility that the fund you are invested in falls in value.

If you put your money into a cash ISA it will carry no investment risk at all, though it would still be at risk from the eroding effects of inflation, which means you could lose money in real terms. But you’d never actually lose money, even if the bank or building society were to go bust, as you would be protected for up to £85,000 per institution under the Financial Services Compensation Scheme (FSCS).

For people seeking a better return from their cash ISA, a stocks & shares ISA may be a consideration, but as with pensions, these involve more investment risk.

Tax considerations

One of the main advantages of a pension over an ISA is tax relief. Everyone gets 20% tax relief on their contributions, which means that, for every £100 you contribute, you’ll actually be putting £125 in your pension.

This applies to anyone who pays into a pension, even non-earners but only up to £3,600 per year including the tax relief, while higher and additional rate taxpayers can get relief equal to their income tax rate.

Note that when you retire, your pension payments are subject to income tax in the same way as your employment income. However, as you are likely to be drawing a smaller income, you may fall below your current threshold anyway and will therefore pay less, or even no tax.

ISAs are a little different. They’re tax-efficient in terms of having your interest or capital gains paid tax-free, but because you'll be paying in money you have earned, you'll have already paid income tax on that amount. Nevertheless, you could use your ISA – especially a Lifetime ISA – to provide an income when you retire, and this will be completely tax-free.

Accessing your pension or ISA

You can't currently access your pension pot until the age of 55, which will be pushed back at the same pace as the State Retirement Age, moving to age 57 in 2028. Currently, anyone over the age of 55 can take a lump sum of up to 25% of their pension pot tax-free. You’re free to withdraw your entire pot if you wish, but anything above the tax-free element will be taxed as earned income on that tax year at the relevant income tax rate.

Many people keep the remaining amount untouched at the outset, instead opting for income drawdown (where they can take an income directly from their pension pot) or purchasing an annuity with their pension funds (which offers a guaranteed income for life).

Conversely, when investing in an ISA you can access your money whenever you want (except in the case of a Lifetime ISA), although there may be a penalty for doing so if you've invested in a fixed rate product. However, this freedom could be a downside to saving for retirement if you don't have good willpower; you should think very carefully about touching the money you have set aside.

When you do decide to withdraw from your savings, you have the option of taking an income from the interest or investment returns on your ISA, or taking a portion of the actual pot itself. However, you must remember that when you start to eat into the capital in your ISA, the interest you earn will become less.

Will my savings last?

This will undoubtedly be a key concern and could sway your decision when it comes to retirement saving. If you’ve saved into a pension and chosen to purchase an annuity, then you will have a guaranteed income for life.

However, if you’ve opted for income drawdown, there’s a chance the pot could run out if you take too much.

ISAs are similar in that respect: if you’re only withdrawing the interest you earn as income, then your savings should not run out (depending on investment performance if you’ve got a stocks and shares ISA). However, if you take a portion of your ISA pot itself as an income, it's possible that you could use this up in the same way as in pension drawdown.

Lifetime ISA or pension: Which is better for retirement?

The Lifetime ISA is a product specifically designed for retirement saving (or for buying your first home, but we’ll concentrate on retirement saving in this guide). It allows you to save up to £4,000 each year into a cash or stocks & shares LISA, and you’ll receive a Government top-up of 25% on all contributions.

Note that there are quite a few restrictions – it can only be opened by savers aged between 18 and 39 and the Government top-up will only be paid until age 50, after which you can still make contributions but will no longer receive the bonus. You’re also unable to access the funds until you’re 60 (apart from in a few specified circumstances) without paying a hefty penalty, so you’ll need to wait a few more years for access than you would with a pension.

Yet for many savers, particularly those who may not benefit from employer pension contributions, a Lifetime ISA can be a valuable addition to their retirement saving portfolio. You can earn interest (or investment returns) in the same way as traditional ISAs, and when you’re able to withdraw the funds, the income will be entirely tax-free. The low investment limit and access restrictions means it’s unlikely to overtake pension saving completely, but it shouldn’t be overlooked by those who want another option to grow their retirement savings pot.

Inheriting ISAs and pensions

There are differences to bear in mind when it comes to inheritance as well. ISA savings can be passed on to loved ones in the event of your death, but only a spouse or civil partner will be able to retain the tax-efficiency. Other beneficiaries can still inherit the savings but without the tax-free wrapper, and they may need to pay inheritance tax on the amount. Find out more in our guide to inheriting ISAs.

Pensions, on the other hand, don’t currently form part of your estate, and so can be passed onto beneficiaries free from inheritance tax. Note that they may have to pay income tax on any funds they take from it, depending on the age when you died and their method for withdrawing the funds.

There’s a lot to think about and it can be incredibly complex, so it's worth reading our guide on what happens to your pension when you die and speak to an adviser for personalised support.

Note the Government has stated that unused pensions will start to be included in inheritance tax calculations from April 2027.

Can you have a pension and an ISA?

Yes! In fact, it’s often recommended to have both options, helping you maximise tax efficiency from every angle. Get advice if you need more help to plan your retirement and manage your finances – an independent adviser can go through the options that would work for you, helping you make the most of your savings. Find an adviser near you.

Is it better to pay into a pension or ISA?

Pensions will always win when it comes to tax efficiency – and a company scheme is a no-brainer – but if it is flexibility as to when you can access your money that is important to you, then the ISA comes into its own.

Yet you need to think about the type of ISA and pension you’re saving into, as each comes with their own benefits and drawbacks. Consider your saving and retirement goals too, not to mention your taxpaying status – if you’re a higher earner and are likely to still be paying tax in retirement, it may be worth maximising the amount you save in an ISA to ensure you can earn at least some form of income tax-free.

You can always use your 25% tax-free lump sum to take a regular income over time. Your age and how close you are to retirement can also have an impact, together with how much risk you’re willing to take with your savings (read more about when to start saving into a pension).

Ultimately, when looking at the pension and ISA debate there is no clear-cut answer. Your decision depends on many considerations, including your attitude to risk, your own level of willpower and what you want out of your retirement. Perhaps it all comes down to the old saying of having your eggs in more than one basket; if you save into both products, you can have the best of both worlds and increase your options when you retire.