Individual savings accounts (ISAs) are ideal for investing tax-efficiently to support a broad range of life goals, from funding your child’s education and saving for a house deposit to growing your long-term wealth.
What’s less well known is that your ISA savings can also be useful in retirement to help control the amount of tax you pay later in life.
Figures suggest many people are already using ISAs in, or close to, retirement, with a third or so of new ISA subscriptions each year made by people aged 55 or over (or 47% if we broaden it out to people aged 45 and over)1.
In part, this could be because people fortunate enough to be able to maximise their annual tax-free pension allowances2, or who have already exhausted or expect to reach their lifetime pension allowance3, need other ways to boost their retirement funding options. Pensions, with their built-in discipline and added tax relief, should certainly be prioritised over ISAs when it comes to retirement investing4.
What it shows, nonetheless, is how an ISA can complement your pension savings.
There are benefits too with a two-pronged approach once you are ready to begin spending your retirement savings because you can potentially use your ISA savings to reduce your income-tax bill.
This is because income from a pension – including the state pension we are eligible to receive from our late 60s, depending on our current age – is taxed in a similar way to employment income, while ISA withdrawals are not taxed at all.
Consider where income tax kicks in
Pension income is not treated in exactly the same way as work earnings. The first 25% of a private pension is usually tax-free – money you can withdraw upfront or over time in the form of lump-sum payments.
However, the remainder is taxable.
So, if your annual pension (excluding the tax-free element) exceeds the personal allowance (which is currently frozen at £12,570 until 2028), you’ll be on the hook for income tax on the extra bit. Withdraw more than £50,270 and you’ll get sucked into a higher tax bracket too5.
Paying tax in retirement is something more people may increasingly need to factor in. This is especially true when you consider that the state pension is set to make up 84% of the personal allowance from 6 April6 – a proportion that looks set to grow further in the next few tax years.
It’s more reason to incorporate some tax planning into your retirement plans, which is where your ISA savings could help.
Using ISAs to increase your personal allowance
Income taken from an ISA isn’t taxed at all, which makes sense when you consider how money is treated when it is first paid into an ISA. Unlike with pension contributions, there’s no tax relief – you don’t get income tax back on the money you use to fund your ISA contributions.
As such, your ISA contributions come out of your after-tax earnings. So, taxing this money when it is being withdrawn would be taxing it twice.
In short, while pensions (including self-invested personal pensions or SIPPs) have the edge over ISAs when paying money in, it’s a different story on the way out. The tax advantages are reversed, which creates an opportunity for those drawing on their pension to reduce their tax bills.
Simply put, you can effectively bump up your tax-free personal allowance by drawing on SIPP and ISA income simultaneously. Take £10,000 out of an ISA one year and add it to a pension withdrawal that matches the personal allowance, for example, and that gives you an annual income of £22,570 and no income tax to pay.
Similarly, with a total ISA pot of £250,000 today you could potentially double your tax-free personal allowance for the next 20 years (or more if we factor in some investment growth).
Extra incentive for high earners
The different tax treatment between SIPPs and ISAs can be particularly advantageous to high earners as there is no limit to the amount of money that can be accumulated within ISAs over a person’s lifetime, subject to the annual allowance. Pensions, on the other hand, are subject to a lifetime cap of £1,073,100, which if breached can incur tax penalties.
And, again, there is a hint that some high earners may be thinking ahead and doing this already. After all, official data shows that more than half of all stocks and shares ISA investors earning more than £100,000 a year subscribed to the full £20,000 annual allowance (a proportion that rises to 62% in the case of those investors with annual earnings of more than £150,000)7.
Choosing how much of your savings to invest in different tax-efficient vehicles is not an either/or question. As ever, it depends on your personal goals and circumstances.
What’s clear, nonetheless, is that ISAs and SIPPs can complement each other.
If you already have an ISA or SIPP with Vanguard, it won’t cost you extra to open the other. Vanguard’s 0.15% annual platform fee covers all your accounts with us. Remember also, that it is capped at £375 per year. So once your total holdings at Vanguard top £250,000, you won’t have to pay any more (individual fund costs aside).
1 Based on the last full tax year for which data is available (2019/2020) as published in Annual savings statistics 2022, updated November 2022.
2 If you’re a UK resident for tax purposes you can usually contribute up to 100% of your relevant UK earnings each tax year – or £3,600 if this is greater – and receive tax relief on those pension contributions. But only up to a maximum annual gross allowance of £40,000.
3 This is currently £1,073,100.
4 Unlike with an ISA, where the funds can be accessed at any time, your pension investments are locked in until you’re at least 55 (rising to 57 in 2028).
5 As of February 2022, the higher-rate tax threshold had been frozen at this level until 2026.
6 The full new state pension will rise to £10,600 per year from 6 April 2022.
7 Annual savings statistics 2022, last updated November 2022.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
The eligibility to invest in an ISA depends on individual circumstances and all tax rules may change in future.
If transferring, you will be out of the market while your investments are being transferred, so you could miss out on any increase in the value of your investments should markets rise. Should markets fall the value of your investment will remain the same.
Any tax reliefs referred to in this document are those available under current legislation, which may change, and their availability and value will depend on your individual circumstances. If you have questions relating to your specific tax situation, please contact your tax adviser.
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