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Pension vs. ISA - How does the tax work?

January 2018

Categories: ISA

If you are planning your own retirement savings on top of any workplace scheme you might have, then trying to choose between the many different options could leave you confused and frazzled.

The new basic state pension of a maximum of £125.95 a week is difficult to live on, so most people try to save for retirement themselves.

Thankfully, there are some helpful carrots to entice us to invest more for longer. The Government offers tax relief or does not charge tax on gains for some types of long-term savings, some of which are specifically designed to help you save for your retirement.


  • Attract tax relief equal to your income tax rate (so 20 per cent if you are a basic rate taxpayer and 40 per cent if you are a higher rate taxpayer).
  • You can get tax relief on private pension contributions worth up to 100 per cent of your annual earnings
  • Contributions up to £40,000 a year are allowed
  • You can take money out from the age of 55
  • Other people, for example, your partner, can pay into your pension for you and you will still get the tax relief
  • You can still get tax relief of 20 per cent on the first £2,880 you pay into a pension each tax year, even if you don’t pay income tax
  • You can save into workplace or private pensions, which can be Self-Invested Personal Pensions (SIPPs)
  • More flexibility in what you can invest in


Lifetime ISAs
  • You can use a Lifetime ISA (LISA) to buy your first home or save for your retirement
  • You can start one if you’re over 18 and under 40
  • You will be able to invest up to a maximum of £4,000 a year in a Lifetime ISA. This amount will make up part of your overall annual ISA allowance, which is £20,000.
  • The government will add a 25 per cent bonus to your savings, up to a maximum of £1,000 per year.
  • They can be saved in cash or stocks and shares.
  • There’s a 25 per cent charge to withdraw cash or assets from a Lifetime ISA. This doesn’t apply if you’re either buying your first home, aged 60 or over or are terminally ill, with less than 12 months to live.



How to make the most of your tax allowances


Private or workplace pensions are the first and most obvious choice for many people.

Unlike other types of investment that may be accessed sooner, funds deposited into a pension are locked away until you are at least 55.

From next year, everyone over the age of 22 in employment, under state pension age and earning over £10,000 must be auto-enrolled at work. If you are auto-enrolled, you are saving a percentage of your salary into a pension pot and so is your employer, although contributions can vary. It’s a bit different for the self-employed, who are not auto-enrolled and may therefore choose to save into a private pension instead.

Tax relief on any money saved into a pension – whether it’s a workplace scheme or a Self-Invested Personal Pension (SIPP) gives a healthy boost to returns and this is why people use them instead of keeping their retirement savings in cash or savings accounts.

Tax relief on pensions means that:

  • For a basic-rate taxpayer, a £1 pension pot contribution actually only costs 80p, because the government will contribute tax relief of 20 per cent.
  • For a higher-rate taxpayer, a £1 pension pot contribution will cost even less at just 60p, because it gets tax relief of 40 per cent.

In both cases, if that money had gone into your bank account instead of your pension pot, you would not benefit from tax relief the government has to offer. Pensions are designed like this to encourage people to save for their retirement.

However, when you reach retirement age and are eligible to start using your pension, you will have to pay income tax on the income you receive from your pension pot.

You don’t pay tax on the first 25p in the £1 taken from your pot (In other words, the first 25 per cent of your pension pot is tax free if taken as a lump-sum), but after that the income tax you will pay is determined, as normal, by your level of income and at the usual rates.

So with pensions, while the contributions receive tax relief, the income you take out of your pension pot at retirement age will have tax implications. When you retire, just like when you work, you still get your annual personal allowance of income that is tax-free, of £11,500. Anything over that will be subject to the usual tax rates.



Self-Invested Personal Pensions (SIPPs) are a type of DIY pension that allow you to choose what you invest in yourself, from a range of SIPP-eligible investment products. This can be a regular stocks and shares portfolio, traditional funds, exchange traded funds, investment trusts and bonds and gilts.

SIPPs usually involve paying a higher management fee than you would pay for a pre-designed private pension fund, because it costs more to administer the wider range of products that can be held within it. However, they do come with the same tax relief benefits as a standard pension; £20 for every £80 you pay in if you are a basic tax rate payer and £40 for every £100 if you are a higher tax rate payer.

While SIPPs mean you have to do the work yourself and pick your investments, they do offer more control over where your money is invested because you are effectively choosing to be your own pension fund manager.

Don’t let that put you off, though. If you are not yet familiar with the different types of investments, a Mutual Fund is an easy way to start investing into your SIPP as it means someone else does the hard work for you.




ISA savings are tax-free, which means that any income you earn from interest in cash ISAs or dividends in stocks and shares ISAs, or any capital gains you make from stocks and shares ISAs, is not taxed. You also won’t have to pay any tax if you withdraw your money from an ISA, which can be done at any time.

Each tax year, you are allowed to make a gain, or profit, on your capital of up to £11,300 before you will get taxed on those gains. If you kept your investments outside of a stocks and shares ISA, and in a dealing account, for example, any capital gains you made on those investments would be subject to capital gains tax (CGT) once those gains had exceeded the annual tax-free allowance of £11,300.

But if your investments are held within a stocks and shares ISA, your gains will not be subject to CGT, nor income tax on any dividend payments.

The benefit of holding ISAs as part of your retirement savings portfolio is that you can keep them going after you retire, allowing you to continue investing tax efficiently. There is no upper age limit on ISAs, unlike pensions, which do not receive tax relief after the age of 75.



Choosing what's best for you

When choosing how much to split between SIPPs or conventional private pensions and ISAs, considering the following should give you a good steer:

  • The limits available for each
  • Your tax bracket
  • What contributions you receive (if any) from your employer
  • The amount of savings you have and would like in the future
  • Your confidence with investing and level of risk aversion
Author: Rebecca O’Connor Categories: ISA