Pension or ISA: where should your next pound go?

Savvy investors will think about how they can maximise the tax efficiency of their pension not just for this tax year, but over their lifetime. The goal for many is to be able to maximise higher rates of relief when building up a pension and earning more, and a lower rate when it comes time to withdraw.

But achieving this balance is becoming increasingly difficult. More people are being pushed into higher income brackets in retirement thanks to the frozen tax thresholds, with the issue potentially exacerbated when their state pension starts. It creates a maze of limits and allowances to wade through to determine the most efficient method.

For those with large and growing pension pots, it raises the question of if some savings are better tucked away elsewhere, like in an ISA or separate investment account, to avoid high rates of tax on retirement income. In truth, all the cost-modelling in the world couldn’t guarantee a perfect way to allocate your earnings for maximum tax efficiency across your lifetime. There are too many uncertainties when you begin to factor in changes in pension policy, inflation rates and market growth.

But there’s some general rules of thumb and considerations that can put you on the path to getting the right mix for you.

The pension rules to know now

Regardless of income, one of the most important things to consider is what your tax rate might be across your lifetime. Making a move that seems most tax efficient now could come back to bite you down the line, so it’s important to understand the basic structure of how you’ll receive your pension, even if the figures are likely to be different by the time you get there.

Pensioners can receive 25% of their pension as tax-free cash, up to the overall lump sum allowance of £268,275 for most people. This doesn’t need to be taken all at the same time and instead can be spread out through retirement. After that, income tax applies the same way it does before retirement, with a personal allowance, followed by basic, higher and additional rate bands. ISAs can also serve as a source of income without being subject to income tax. Those that have ISA and pension savings may opt to keep their pension income just below £50,270 to stay in the current basic rate tax band, and supplement this income with ISA savings because these come with no tax implications.

Pensions will be included in estates for inheritance tax in April 2027, meaning that leaving a pension largely untouched to pass money down through a pension has lost some of its appeal. Previously, pensions could generally be passed down free of inheritance tax and then used by the beneficiary at their own rate of income tax, or without income tax if the person who passed away died before 75. Now, they could face both inheritance tax (40% on the value of your estate exceeding £325,000) and income tax, removing that tax efficiency.

For example, let’s assume someone who died over age 75 passed down an estate worth £1,000,000 with a £200,000 pension, and any allowances had been used. This means the £200,000 pension would face the full inheritance tax rate of 40%, leaving the pension at £120,000. The beneficiary, who is a higher rate taxpayer, could then face another 40% tax when that pension was translated into income, making its true value to the beneficiary £72,000.

Someone who would have otherwise saved as much as possible in a pension and then left the excess to be passed down might look to save the extra money elsewhere.

Pensions for £100,000 earners

The milestone of reaching a £100,000 salary can be dampened by the tax trap that come with it. But if you’re smart with your pension savings, you can enjoy the benefits of a bigger salary without feeling the extra tax drag. The £100,000 mark is when your personal allowance begins to shrink from £12,570, reduced by £1 for every £2 of taxable income over £100,000. But, because your pension contributions are not subject to tax, they can take you back below that threshold and allow you to hold on to your annual allowance while building up your pension pot more quickly.

Employer contributions will also be a big asset at this stage. Many employers will match your pension contributions when you increase your personal contribution, which can mean thousands more in your pot each year.

You’ll be receiving 40% tax relief on these contributions, and the effective rate of relief is even higher if you’re able to claw back any lost personal allowance. If you’re able to receive 40% tax relief or more on your contributions going in, the benefits of tax-free growth on your pension investments, and then only withdraw within the basic rate of tax during retirement, you’ll find yourself in a sweet spot.

For those with children, it can also mean hanging on to childcare support worth thousands each year.

ISAs shouldn't be counted out. They can help cover the shorter to medium-term expenses, like sending children to school or saving for a new house. In terms of retirement savings, some of the benefits will start to diminish when you tip over £1,073,100 and have therefore maxed out the 25% tax-free cash you can receive. At this point, you might benefit by looking to save through other vehicles to avoid high rates of tax when retirement comes.

What to consider when your pension allowance starts shrinking

If your adjusted income (all income plus employer pension contributions) is over £260,000 a year and your threshold income (earnings less personal pension contributions) is over £200,000, your pension annual allowance will begin to be tapered to a minimum of £10,000. Any contributions made to your pension in excess of this amount will be subject to the annual allowance charge, which is taxed at the same rate as the highest rate of income tax you pay. However, it isn’t considered to be income tax, which means you can’t offset it against allowances, losses or relief.

This effectively means that you’ll face a tax charge on any money which is contributed to your pension beyond the allowance and again when it comes time to use that pension income, less any tax-free lump sum allowance.

Using what remains of your pension annual allowance still tends to be a tax-efficient move, since it would be facing a high rate of income tax otherwise. If you have recently been put in this bracket, you may also be able to squeeze out a bit more relief by carrying forward any unused pension allowance from the previous three years.

For example, if someone had an adjusted income of £300,000 and has a threshold income above £200,000 with no carry forward, the tapered annual allowance will be £40,000 (£60,000 minus £40,000/2).

Other investment wrappers

ISAs are an obvious place for further tax relief, as they protect investments in the wrapper from income and capital gains tax, with no tax on withdrawals either. If you’re contributing past your pension allowance, this would typically make ISAs a more efficient wrapper for extra cash. But many people who are in the range of exceeding their pension allowance have used their £20,000 ISA allowance as well.

For additional investments, it can be efficient to ensure that a spouse or civil partner’s pension and ISA allowances are maxed out. Outside of a tax-free wrapper, capital gains will face a tax of 24% for higher rate taxpayers. Because this tax only applies to gains, not the original amount you invested, and because it sits below the income tax rate for higher and additional rate taxpayers, it could end up costing you less than trying to keep that money in a pension wrapper, unless those contributions are coming from the employer and at no extra cost to you regardless.

The same would be true for dividend tax on these gains, though more marginal at 35.75% for higher rate and 39.35% for additional rate taxpayers.

If you’re in this position, it’s also worth considering a financial adviser. While there’s an upfront cost, it could save you a much larger sum down the line to have someone run the numbers on your specific situation and keep it under regular review.