Pension vs ISA: how they can work together to help you prepare for later life

By Jo Bentham18th March 2022

A pension and an ISA are two of the most powerful, tax-efficient investment products available. And whilst a pension may seem the most obvious choice when looking to financially prepare for later life, an ISA also has the potential to be an attractive supplement.

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The core advantage of both a pension and an ISA are their generous tax reliefs that can be incredibly beneficial in maximising target returns. 

But in addition, the two have their own, individual features that, when used in conjunction with one another, are unrivalled in their potential to aid experienced investors in building a healthy retirement pot.  

Please note: this information is for educational purposes and is not pension advice. For that, speak to an independent financial adviser. 

 

Comparing a pension and an ISA

 
Product Types

The three main types of pension are the widely-known state and workplace pensions and the Self-Invested Personal Pension (SIPP), a favourite among experienced investors in particular. 

  • State pension – This is a regular income provided by the UK Government. State pension entitlement and the amount you’re entitled to depends on your record of National Insurance contributions.

  • Workplace pension – These are paid into by you and your employer. Most employees are automatically enrolled into a workplace pension. 

  • SIPP – This will be set-up and managed by you (or an appointed administrator), allowing more control and choice over your pension investments. You can either make regular contributions to your SIPP, or make one-off contributions when it suits you. 

For Directors of limited companies, there is also the option of a Small Self Administered Scheme (SSAS). A SSAS is technically a defined contribution workplace pension, but it can be set-up by Directors for themselves, their employees and also family members.

Similar to a SIPP in many aspects, a SSAS allows for greater control over how the pension is invested, with more investment options than standard pensions, and they can also be an excellent vehicle for business growth

When considering an ISA, there are four Adult ISA products to choose from – the Cash ISA, Stocks and Shares ISA, Innovative Finance ISA (IFISA) and Lifetime ISA. 

  • Cash ISA –  A low risk cash savings-based product protected by the Financial Services Compensation Scheme (FSCS). 

  • Stocks and Shares ISA – A high risk/high target return investment-based product whereby investors gain exposure to the equities market.

  • IFISA – Also a high risk/high target return investment-based product. With an IFISA, experienced investors can access the peer-to-peer lending and debt-based securities market under the tax-free ISA wrapper. 

Lifetime ISA – A Government-backed ISA product designed specifically for people looking to purchase their first home or save for retirement. When saving with a Lifetime ISA, the Government boosts your contributions with a 25% bonus, up to a maximum of £1,000 per year.

 
Tax Reliefs 

Out of the two, the tax reliefs offered by an ISA are the most attractive on the face of it. This is because all funds saved or invested and all interest earned within the ISA wrapper are free from income and capital gains tax forever, even at the point of withdrawal. 

To truly recognise the power of the ISAs tax reliefs, it’s worth considering that to target 7% – a figure often targeted by the IFISA – outside of the ISA wrapper, it would equate to a Gross Equivalent Return of over 12% for additional-rate taxpayers. 

On the other hand, you can only withdraw 25% of your pension fund tax-free, the rest will incur tax. 

However you do benefit from tax relief when paying into your pension. Basic-rate taxpayers and non-earners receive 20% tax relief on contributions, whilst higher-rate taxpayers and additional-rate taxpayers receive 40% and 45% tax relief respectively. 

With regards to inheritance tax, pensions do not form part of your estate after death, therefore this is not payable, no matter who your chosen beneficiary. 

However, this is not the case with an ISA. Unless your ISA is inherited by a spouse or civil partner, inheritance tax may be payable – when left to any other beneficiary – on the value of the ISA at the date of the holder’s death, depending on the value of the whole estate.

 
Allowances

Pension contributions are subject to both an annual allowance and a lifetime allowance. As of 2021/22, the former is £40,000 for most people, and the latter £1,073,100.

However, for higher earners, a pension’s annual allowance becomes less and less generous due to the pension taper.

The pension taper affects any individual who has an adjusted income of over £240,000 and a threshold income of over £200,000. For every £2 your adjusted income exceeds £240,000, your annual pension allowance for the year decreases by £1, down to a minimum reduced annual allowance of £4,000. 

By comparison, the annual ISA allowance for 2021/22 – and 2022/23 come 6th April – is £20,000, for everyone. 

The Lifetime ISA however has its own, lesser subscription limit of £4,000. As a result, though the Government top-up offered on a Lifetime ISA could be great when saving for retirement, this low subscription limit may mean other ISA products could prove more beneficial for experienced investors able to contribute more. 

It’s clear that whilst the tax reliefs offered on an ISA are more beneficial than those offered by a pension, the amount that can be contributed is significantly less. 

And though the ISA allowance may not seem a particularly large amount for some experienced investors, it’s clear it has the potential to be advantageous when used to its maximum, with around 2,000 ISA millionaires currently in the UK and this number expected to soar over the coming years.

What’s more, utilising ISA transfers is an excellent method of maximising the ISA allowance further, as they allow you to ensure that past allowances are still working hard to achieve your goals without affecting your current allowance.

 
Investment Choice

If you’re an experienced investor wanting more control over where your pension funds are invested, a SIPP will likely be an appropriate consideration. 

Whilst workplace pensions are typically automatically invested into a fund on your behalf, you are able to choose the specific investments held in your SIPP, and the choice is far more comprehensive than those offered by standard pension schemes.

With an ISA, it’s possible to select where both a Stocks and Shares ISA and an IFISA are invested. To choose your own stocks and shares, you will need a “self-invested” Stocks and Shares ISA, whereas with an IFISA, it is standard practice to select the individual investments held inside. 

An IFISA allows for investment into alternative assets – such as property bonds and SME loans – making the product a key consideration for investors looking for increased diversification and exposure to assets uncorrelated with the volatile equities market. 

In addition, many IFISAs offer quarterly interest payment options, a particularly beneficial feature for those wanting a steady, fixed income throughout retirement. 

 
Accessibility

At present, you can not access your state pension from the Government until you reach “state pension age”, which is currently 66 for both men and women. 

The age at which you can access your workplace pension(s) differs from provider-to-provider, but it is typically between the ages of 55 and 65. 

For a SIPP, you must be 55 for above to access your funds and begin to draw down. 

On the other hand, there are no age restrictions with regards to accessing your Cash ISA, Stocks and Shares ISA or IFISA. You can, theoretically, access your capital at any point – a useful feature for those looking to retire early in particular. 

It is also worth bearing in mind that a Stocks and Shares ISA should be considered a long-term investment, with funds invested for a minimum of five years in order to allow time for any falls in value to recover. 

An IFISA can be considered a medium-term investment, with both two and four year fixed-term periods typically offered (though this will differ depending on provider and the underlying asset). But due to the fixed-term nature of the product, many providers will not allow you to access funds within your IFISA until the term ends.

However, if you are using a Lifetime ISA, you can not access the funds until you are 55, unless you are using them to purchase your first home.

 
Fees

You will not pay any fees for a state or workplace pension, however a SIPP will typically have ongoing management fees which will vary from provider-to-provider. 

With an ISA, this is completely dependent on the provider, as well as the type of ISA. A Stocks and Shares ISA will usually have ongoing fees, which can be a percentage of the funds you invest, a set monthly payment and/or a fixed fee based on the shares or funds you purchase.

Most Cash ISAs will have no fees, and many IFISA providers also do not charge investors any fees, but it’s important to check this with specific providers before opening an account and/or investing. 

 

Using an ISA to supplement your pension

For higher earners in particular who are able to invest more than the pension allowance each year, the ISA could be an excellent supplement, with its own £20,000 allowance that can provide an important boost.


With a variety of product options available – and with the likes of the IFISA allowing exposure to attractive alternative investments typically out of bounds with standard pensions – there is likely to be an ISA product that could make an excellent addition to your retirement portfolio.