With the UK’s tax burden reaching its highest level since the 1950s, and the fastest-falling living standards in a generation, it’s more important than ever to combine your tax-efficient pension and ISA allowances.
At a glance
For many people in the UK, pensions and ISAs remain the most popular and tax-friendly ways to save.
Pensions are the most tax-efficient, while ISAs are simple, flexible and can be accessed at any time.
Using all your pension and ISA allowances before this tax year-end will bring your tax bills down and help buffer the impact of high inflation and interest rates in the short- and long-term.
The decision to freeze income tax personal allowance and higher rate thresholds, coupled with the lowering of the additional rate threshold to £125,140 means that most of us will pay more tax. In addition, the tax-free allowances for Dividend and Capital Gains Tax will be cut this year, and again in 2024.
Rising energy prices and the cost of living have pushed up interest rates to levels not seen since the 2008 financial crisis.1
These changes mean you might need to invest more to stay on track to achieve your long-term goals. It’s definitely the year to make the most of all your pension and ISA allowances ahead of tax year-end on April 6th.
It’s more important than ever that your financial plan involves both pensions and ISAs, to make every penny of your available tax allowances count.
Taking financial advice to help you decide how to split your money between pensions and ISAs means you’ll put yourself in a better position both now, and in the future.
Why you should use pensions and ISAs together
Pension or ISA? It’s not an either/or question, and a combination of both is often a tax-savvy way to save, especially in the current climate.
Of the two, pensions are still the most tax-efficient, since the basic-rate tax relief guarantees you a 20% cash boost from the government on contributions you make subject to certain limits. If you’re still in a workplace pension scheme, your employer will also be contributing at least 3% of your qualifying earnings.
You can access your pension from age 55, though this is set to rise to 57 in 2028. And there’s another plus; you can choose who you pass your pension pot on to, when you die. Since pensions fall outside of your estate when it comes to paying Inheritance Tax, that’s a wonderful thing to leave to a loved one.
Why save with an ISA?
ISAs are hugely popular. They’re a tax-efficient, simple and flexible way to save. Around £72 billion was invested in adult ISAs in 2020/21.2 There are various types of ISA, including Cash, Stocks and Shares, lifetime and innovative finance.
Since you don’t pay tax on interest, income or capital gains in any of these ISAs, you don’t need to declare them on your tax return.
ISAs have no age restrictions, so you don’t need to wait until you’re 55 to access your money. That flexibility means you can have cash ready for rainy day emergencies, as well as for other goals that are a little further in the future.
So, using a combination of pensions and ISAs is a good way to plan for short, medium, and long-term goals.
How can I balance pensions and ISAs?
Creating a flexible, tax-efficient retirement plan to suit you, and everything you’re planning to do, usually means using a combination of pensions, ISAs and potentially, other types of investment too.
Choosing the best way to balance that mix will depend on how much money you think you’re going to need, when you want to start accessing that money, and even whether you want to pass money on.
It’s a personal choice and making the right decision can feel complicated.
That’s where advice can make a huge difference to your future financial wellbeing.
To help you get started, here are some things to consider:
ISAs and pensions – the benefits
|Can I have instant access?
|Not before age 55 unless you retire on severe ill health grounds, or have a protected retirement age
|How much can I pay in?
|£20,000 each tax year
|£3,600 gross or 100% of net relevant earnings (whichever is higher), subject to annual allowance limits (currently £40,000 but can be lower for high earners)
|How much tax will I pay on it?
|You don’t pay Income or Capital Gains Tax on any gain you make
|25% tax-free lump sum at retirement, but then you pay Income Tax on the remaining 75%
|Do I get tax relief on my contributions?
|Yes. You get an immediate 20% from the government on any contribution. Higher or additional rate taxpayers can claim further relief via self-assessment
|What happens when I die?
|Your ISA is counted as part of your estate for Inheritance Tax (IHT) purposes
|Pension funds aren’t currently included in your estate for IHT purposes. Death benefits are tax free if paid before deceased’s 75th birthday, but subject to beneficiary’s marginal rate of tax if deceased was over 75 at date of death.
Using a pension to reduce tax and reclaim allowances
Another handy advantage of personal pension contributions is that they reduce your taxable income, and therefore the amount of tax you’ll pay. They also may help you hold on to certain benefits and allowances, by keeping you within the threshold. All of which means you’ll have more money to save or spend.
You can’t use ISAs in the same way since any contributions you make come from your taxed income.
For example, if your adjusted net income is £125,140 or more this tax year, you’ll lose all your entitlement to the personal allowance, as your personal allowances reduces by £1 for each £2 you exceed £100,000 of income. But by making a pension contribution of £25,140, you could bring your taxable income down to £100,000. Which means you’ll still be entitled to your personal allowance.
Pension contributions can also help you hold onto your Child Benefit, which you would lose if one partner or parent in the household earns more than £50,000.
For example, someone earning £52,000 would have to repay 20% of any Child Benefit they receive via self-assessment. But if they contributed £2,000 (gross) into a pension, they’d still be entitled to Child Benefit – and sidestep the tax charge.
What’s more, investing into a pension may help higher earners bring their income below the additional rate tax threshold of £125,140.
In addition to the 20% basic-rate relief, higher or additional-rate taxpayers can also claim an extra 20% or 25% as applicable relief on pension contributions through their annual tax return.
Planning your income in retirement
You can take 25% of your pension fund tax-free. After that, the retirement income you take from a pension is taxable, whereas you can access funds from an ISA anytime.
That tax saving on income taken from ISAs in retirement can be considerable. But it’s worth remembering that any money you put into your ISA has had Income Tax deducted before you invest it.
Using that, combined with your personal allowance, means you can plan your pension income tax-efficiently.
Pensioners usually pay lower Income Tax rates than they did while they were working. This means that, for the vast majority, the tax relief gained when putting money into a pension is more than the tax rate on the money taken out.
But using your pension together with ISA income gives you even more tax-planning options.
Bear in mind that most pensions are not subject to Inheritance Tax (IHT) when you die. ISAs are subject to IHT, except if you’re passing the money directly to your spouse or civil partner. So you’ll need to think about whether you want to prioritise income from your ISA savings, so you can leave more of your pension pot to your loved ones, when you die.
Take advice before tax year-end
Using pensions and ISAs together is increasingly important for all savers – not just those who are close to the ceiling of their lifetime allowance.
The last few weeks of this tax year, and the beginning of the next one, provide immediate opportunities to boost your financial wellbeing, in challenging times.
The value of an investment with St. James’s Place will link directly to the performance of the funds selected and may fall as well as rise. You may get back less than the amount invested.
An investment in a Stocks and Shares ISA will not provide the same security of capital associated with a Cash ISA.
The levels and bases of taxation, and reliefs from taxation, can change at any time and are generally dependent on individual circumstances.
Please note that Cash ISAs, Lifetime ISAs and Innovative ISAs are not available through St. James’s Place.
1Overview of the November 2022 economic and fiscal outlook, Office for Budget Responsibility, November 2022
2Commentary for annual savings statistics, Gov.uk, June 2022
SJP Approved 01/03/2023