Is an ISA the missing part in your retirement plans?

Pensions are the ultimate retirement saving tool. The combination of tax relief on contributions, tax-free growth and relatively generous allowances, means they pretty much always trump the alternative options. Then there’s the fact that your employer will pay in too, if you’re in a workplace pension.

But that’s not to say that they should be the only way you save for later life.

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Paying some money into a stocks & shares individual savings account (ISA) - alongside your pension - can make your retirement finances a whole lot more flexible and cut your tax bill.

Here are a few reasons why you can benefit from having both a pension and an ISA in your retirement planning armoury.

1) ISAs can help you stay in the basic-rate tax bracket

ISAs and pensions are both tax-effective ways to save for the future, but they work in the opposite way.

While pensions get the benefit of tax relief on contributions – which is crucial for the long-term growth of your pot – you’ll only be able to take 25% tax free, with the rest subject to income tax.

ISA contributions, on the other hand, don’t benefit from upfront tax relief, but there will never be any tax to pay when you take money out.

This can be really helpful when it comes to managing tax in retirement.

Let’s say you’re sailing close to the higher-rate tax threshold, but you need to increase your income. If you’ve also got funds in an ISA, you can take money from that pot instead and get the income you need, without getting bumped into the higher-rate tax bracket.

Paying less tax on your income isn’t the only reason to try and remain in the basic-rate tax bracket. It could also reduce the tax you pay on any savings and investments that aren’t being sheltered by a pension or ISA.

That’s because, once you become a higher-rate taxpayer, the tax you pay on savings will jump up and your personal savings allowance (the amount of savings interest you can earn tax-free) will drop from £1,000 to just £500.

Likewise, the rate of capital gains tax (CGT) that could be payable on investment or property sales will jump from 18% to 24% when you enter higher-rate territory. And, if you earn money from dividends, the rate of tax you’ll pay will rocket from 8.75% to 33.75%. From April 2026, these rates will rise to 10.75% and 35.75% at the basic and higher rates, respectively.

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The number of pensioners who are paying higher rates of tax (at 40% or above) has more than doubled to just over one million over the last four years, according to research from pension consultants LCP. 

This has largely been driven by the ongoing freeze to income tax thresholds and rising pensioner incomes.

2) It’s easier to take a lump sum out of an ISA

As all ISA withdrawals are tax-free, it’s much easier to take a lump sum out of your ISA than your pension.

Although you can take 25% of your pension as a tax-free lump sum when you move into income drawdown or buy an annuity, other lump sum withdrawals can come with a hefty tax bill and potentially push you into a higher-rate tax bracket.

For example, if you take a so-called uncrystallised fund pension lump sum (UFPLS) from your pension (before you buy an annuity or go into drawdown), only the first 25% of your withdrawal will be paid tax-free and you’ll pay income tax at your marginal rate on the rest.

Or, if you’ve already taken your pension tax-free cash, future lump sum withdrawals will be wholly taxed at your marginal rate.

3) ISAs increase your tax-free cash

Following the abolition of the lifetime allowance, the amount of tax-free cash that you can take out of your pension during your lifetime is now capped at £268,275 (unless you previously applied for pension protection).

That means that if your pension is worth more than the old lifetime allowance (£1,073,100), you can still carry on paying into your pot, but further contributions won’t increase the amount of tax-free cash you can eventually take.

However, if you divert contributions to a stocks & shares ISA instead, you’ll increase the amount of tax-free capital you’ll have access to in retirement (you just need to be mindful that you wouldn’t get tax relief on contributions).

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4) You can access your ISA at any age

Even if you earmark savings in your ISA for retirement, you can get your hands on your money whenever you want.

That’s different to pensions, which cannot be touched until age 55 at the earliest (rising to age 57 in 2028).

Although that restriction is helpful, in so far as it safeguards your retirement savings for later life, it can put some people off really pumping money into their pension.

With an ISA, that psychological hurdle is removed and you can top up your retirement savings freely, without placing the money too firmly out of reach.

This can be particularly helpful when it comes to the pre-retirement years.

Finances in your 50s and 60s can be tricky to manage. You may need to stump up cash to put your kids through university or help them on to the property ladder. Your work situation might change too – care commitments may mean you need to scale back your hours, or you might decide you’d simply prefer to work part-time.

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Even if you work full time, you might find that you don’t earn as much as you did – while you might assume that your pay will continue on an upwards trajectory throughout your career, that’s often not the case. According to stats from the Office for National Statistics (ONS), average earnings actually peak at age 47.

But, if you’ve got money in an ISA, you’ll have access to the lump sums or income that you might need.

Once you’re eligible to start taking benefits out of your pension, it may still make more sense to call on your ISA.

Taking money out of your pension could land you with a tax bill and have a detrimental impact on your future retirement income (the less money you have in your pot, the less it will grow).

And, of course, if you don’t need your ISA to manage the tricky mid-life years, the money will still be there to support you through retirement.

ISAs v pensions summarised

For most people, a pension should be the backbone of your retirement saving – the power of tax relief to grow your fund should not be underestimated. Plus, you can usually invest much more into pensions than you can into ISAs. But, in return for the various tax benefits of saving into a pension, they are bound by pretty rigid rules.

So, by channelling some of your savings into a more straightforward ISA, you could add much-needed flexibility to your retirement income and manage the amount of tax that you pay – especially if your pension is already looking pretty healthy.

If you aren’t sure how to split your money between pensions and ISAs, or how to manage your retirement income in the most tax-effective way, it may make sense to consult a financial planner.