Why pensions and ISAs can both help make your financial plan more tax-efficient

05/09/2024
By David Snelling

One question that sometimes comes up when I’m speaking to a potential new client is with regard to the apparent choice between putting money into an ISA or a pension.

My first reaction is to push back on any suggestion that it’s actually a choice between the two investment options. You are very much able to make use of both, and they each have tax incentives and other features that you can take advantage of.

So, in this article, read about some of the differences and similarities between pensions and ISAs, and how you can use them to tax-efficiently save and invest for the future.

ISAs are a highly tax-efficient way for you to save and invest

With Morningstar reporting that the current total value of holdings is £741 billion, it’s fair to say that ISAs have become a personal finance success story since they were launched in 1999.

In 2024/25, you can save or invest up to £20,000 each tax year, regardless of your earnings. This applies to each individual, so a couple can save £40,000 tax-efficiently between them.

The tax efficiency stems from the fact that you don’t pay any tax on any growth, whether that’s interest or returns, in your ISA.

Furthermore, if you invest in a Stocks and Shares ISA, you don’t pay tax on any dividends from shares, and you don’t pay Capital Gains Tax (CGT) on any profits made on investments.

This is an important point to bear in mind when you consider that your CGT Annual Exempt Amount has reduced from £12,300 in 2021/22 to just £3,000 in 2024/25. That means you will typically pay CGT on any investment gains you liquidate above that figure in a single tax year.

This reduction makes finding tax-efficient investing options imperative, and it can make sound financial sense to ensure you make ISAs a key component of your investment planning.

How to save and invest with an ISA

While there’s no doubt that the tax efficiency they provide make ISAs an attractive saving and investing option, how you utilise them will depend on your financial plans.

There are various kinds of ISAs, and the two most popular are Cash ISAs, which work much like a normal savings account, and Stocks and Shares ISAs, through which you can invest your wealth. You can split your £20,000 ISA allowance across your ISAs each year as you see fit.

If you’re saving for a shorter-term goal, a Cash ISA may be preferable. Whereas, for goals that are five years away or more, investing may be preferable, making a Stocks and Shares ISA more appropriate. The tax advantages, especially when compared with the CGT that you could be liable for with non-ISA investments, can make it advantageous to prioritise your ISA investments out of your £20,000 limit above simple savings options.

It’s also worth remembering that the £20,000 limit applies to each individual regardless of earnings, so you can look to maximise your combined £40,000 allowance with your partner.

It’s worth noting that while ISAs are free from Income Tax, CGT, and Dividend Tax, they do contribute to the value of your estate and are potentially taxable for Inheritance Tax (IHT) purposes.

Your pension fund will likely be the cornerstone of your retirement planning

The income you live on once you retire and are no longer earning a regular salary could be drawn from various sources, including investments and other assets. But, it’s likely that the bulk will come from your accumulated pension fund.

From a tax efficiency point of view, you benefit from Income Tax relief at your marginal rate on your personal pension contributions. Basic-rate relief is paid at source, so for every £80 you contribute, the government adds an extra £20. You can then claim higher- and additional-rate relief through your self-assessment tax return each year if you have income in either of these brackets.

You can access your fund from age 55, rising to age 57 in April 2028. Pension Freedoms legislation introduced in 2015 offers flexibility in how and when you can draw from your fund. The first 25% of your pension (up to £268,275) can be taken free from Income Tax.

There’s an annual limit on tax-efficient pension contributions

Your personal contributions up to £60,000 gross each year are eligible for tax relief. This is known as your “Annual Allowance”. Your Annual Allowance may be lower if your earnings exceed certain thresholds, or you have already flexibly accessed your pension.

You can also utilise the “carry forward” facility to make use of any unused Annual Allowance from three previous tax years. There is no limit on the total amount you can have in your pension fund, either.

Even if you have no UK earnings, you can still contribute up to £3,600 gross into a pension – essentially £2,880 of contributions with tax relief included. This makes pensions a useful tax-efficient savings option if your spouse or partner is not working or you are currently living and working overseas and have no “relevant UK earnings”.

From an estate planning perspective, unlike ISAs, your accrued pension fund will typically fall outside the value of your estate and be exempt from IHT. However, your beneficiaries may have to pay Income Tax when inheriting your pension wealth if you die over age 75.

It’s not a binary choice between these 2 investment options

As you read at the start of this article, investing in ISAs and your pension fund is not an either-or scenario.

Both options provide flexibility and tax efficiency, and so you could look to use both in alignment as part of your investment and income planning, rather than separately.

When doing so, it’s worth taking into account when and why you may want to access assets and savings, as that will be a determining factor in how long you invest for, and which option you choose to invest in.

For example, the ability to draw from your ISA at any time, rather than having to wait until you are 55 or 57, can make one ideal for earmarked specific investment purposes, such as school fees for your children.

The longer-term nature of pensions can make them a better and more appropriate option for retirement savings. Even so, that doesn’t preclude you saving for your retirement in an ISA, especially if you have used all your Annual Allowance in a particular year.

Both ISAs and pensions could feature in the Budget on 30 October

Given the potential for key changes that could impact on your personal finances and long-term financial planning, the upcoming Budget on 30 October could be one of the most impactful statements for some time.

While I’d suggest that the chancellor is unlikely to tamper with such a popular savings option as ISAs, there has been plenty of speculation that the rules around pension contributions may change.

In particular it’s been suggested that the chancellor may introduce a new flat rate of tax relief of perhaps 30%. While such a rate would clearly benefit basic-rate taxpayers, it would penalise you if you pay a higher rate of Income Tax.

The potential scope of the changes, and the fact that you may only have a limited amount of time to mitigate the impact on your income and tax planning before any changes come into effect, helps to underline the importance of effective financial advice.

We can help you assess the effect any changes announced could have on your financial planning and outline an appropriate course of action for you.

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