• Pensions are designed to help you fund retirement, but should you use an ISA too?
• While pensions have generous tax benefits, they also have restrictions on how you can access your money.
• We help you weigh up the pros and cons when saving for long-term goals.

For many people in the UK, minimising the impact of tax on your investments means investing in an individual savings account (ISA) or a pension.

But is one better than the other when it comes to saving for long-term goals such as retirement?

While pensions, such as self-invested personal pensions (SIPPs), are specifically designed to help you fund retirement, there’s no reason why you can’t use your ISA savings for that purpose too. However, you can access your ISA savings at any time, so leaving them intact for retirement could require some discipline.

In this article, we’ll take a look at some of the considerations when weighing up ISAs and SIPPs, starting with a quick overview of the tax rules. 

What tax benefits do SIPPs and ISAs offer?

Let’s start with ISAs. You can invest up to £20,000 in an ISA each tax year, with your ISA investments growing free of income, dividend and capital gains taxes. When you come to take the money out – which can be done at any time – withdrawals are tax-free.

The way the tax works on personal pensions such as SIPPs is quite different. The government automatically tops up your contributions by 20% for basic-rate taxpayers, with higher-rate taxpayers able to claim an additional 20% by filing an annual self-assessment tax return.

If a basic-rate taxpayer contributed £80 to a SIPP, for example, the government would top up their contribution by £20, making a £100 contribution in total. A higher-rate taxpayer could claim an additional 20% of that £100 back, i.e., £20 (or 25% for additional-rate taxpayers).

Like ISAs, there’s a limit on how much you can put into a SIPP – the annual allowance – which is £60,000 for the 2023-24 tax year.  You can usually qualify for tax relief on SIPP contributions made during any tax year worth up to 100% of your annual earnings, up to the annual allowance¹. Even if you have no earned income, you can still get tax relief on the first £2,880 you pay into a pension each tax year.

It is also possible to ‘carry forward’ unused pension allowances from the previous three years, provided you were a member of a registered pension scheme during the relevant time period².

While the investment growth inside your pension is tax free, when you take money out of a pension, you have to pay income tax. (There is a minimum age before you can take your money, which we explain further below.)

Up to 25% of your pension withdrawal can be tax free (subject to a lifetime limit of £268,275 across all your pensions) and the rest will be treated as taxable income. Somebody who is a basic rate taxpayer, for example, could take out £10,000 from their pension, with the first £2,500 tax-free and the remaining £7,500 taxed at 20%. That would equate to an effective tax rate of 15% (£7,500 x 20% = £1,500, or 15% of £10,000).

Mathematically, this shows the attraction of pension contributions.  If you get 20% tax relief on the contribution but only pay an effective 15% tax when you withdraw there’s a “tax uplift” which helps boost the after-tax value of the fund.

How SIPPs and ISAs compare

* Up to a maximum of £268,275. ** Depending on earnings in current tax year. Higher earners may have a lower limit. Limit correct as at 2023-24 tax year. *** Limit correct as at 2023-24 tax year. **** If you die after 75, beneficiaries will pay income tax when they withdraw from the SIPP at their marginal (highest) rate of income tax.

Tax uplift

If you’re a higher rate taxpayer, the tax uplift is potentially even greater because you are receiving 40% tax relief upfront but could pay 20% income tax on withdrawals.

Let’s take an example: 

• Claire is 55 and has £6,000 of surplus income she wants to save each year until she retires at age 60.
• Her salary is £80,000 and she also has £15,000 of rental income which she expects to continue into her retirement.
• As Claire is a higher rate taxpayer, she can claim 40% tax relief on her pension contributions. You can see the difference this tax relief makes in the table below, comparing what Claire would have in an ISA or SIPP at the end of 5 years. We’ve assumed the ISA and SIPP are invested for five years with an annual return of 5% a year before costs.

Source: Vanguard calculations assuming an annual return of 5% before costs.

But this is only half the story. We also need to consider the impact of tax when Claire comes to take the money.

Claire was a higher rate taxpayer when she was saving into her pension but is a basic-rate taxpayer when she retires, as she’s earning below £50,271³. Provided Claire stays below this threshold, she’ll only pay 20% income tax.

The likelihood is that Claire can withdraw all of her pension over time without going into the 40% income tax band. As such she will likely pay 20% income tax on her pension withdrawal, of which 25% will be tax free anyway.

Once you take the tax picture into account, the calculations looks more like this. 

Source: Vanguard calculations assuming an annual return of 5% before costs.

Taking tax into account has narrowed the gap, but Claire is still almost £15,000 better off from investing in the SIPP rather than the ISA. That could make a real difference to her ability to spend in retirement.

There is a minimum age from when you can access your SIPP⁴, so if you need access to your money before this age, a SIPP may not be appropriate for you. Because you can access your ISA at any time, some people use them to help save money for early retirement.

Think about your goals

Ultimately, whether you are better off or not investing in an ISA or SIPP depends on your personal circumstances, particularly your tax position, and when you want to retire. 

For those wanting to pass on something to their heirs, it’s also important to note that SIPPs typically fall out of an investor’s estate for inheritance tax purposes. 

¹  This annual allowance is reduced if your threshold income is over £200,000 and your adjusted income is over £260,000. These limits are different for earlier tax years. For more information, speak to a financial adviser.

²  To benefit from tax relief, your relevant earnings (or gross employer contribution) must be at least equal to the amount you wish to contribute.

³  These figures are for the 2023-24 tax year.

⁴  This is currently 55, rising to 57 from 2028.