Which one should you prioritise?

Pensions and ISAs are both powerful tools when saving for retirement – they’re relatively simple, tax efficient, and can boost your nest egg in different ways.

Picking the best option isn’t straightforward, however, particularly if Rachel Reeves chooses to cut the cash ISA limit to £4,000, as has been rumoured, or even scraps it altogether.

Choosing the right one could increase your retirement income by thousands. So, which one should you prioritise? Here, The i Paper spoke to the experts to find out.

What is a pension?

A pension is a savings scheme used to put money away for retirement. It offers tax relief at a basic rate of 20 per cent, which can be claimed from the Government by your pension provider.

It is long term and inaccessible until the saver is at least 55 (rising to 57 in 2028). Unlike a regular savings account, which offers interest, a pension is invested and can therefore lose as well as gain money.

There are three main types of pensions in the UK: the state pension, workplace pensions and private pensions.

What is an ISA?

An ISA is an individual savings account, which allows you to save up to £20,000 per tax year without having to pay tax on any returns.

The two main types include cash ISAs – similar to a regular savings account as you receive interest on the money you save – and stocks and shares ISAs – where your money is invested, and returns are paid courtesy of any gains the investments make.

Recently, it has been reported that the Chancellor is considering changes to the cash ISA regime.

Currently, it allows savers to protect £20,000 of their money from tax each year. But this could be slashed to just £4,000 – a fifth of its current amount or scrapped altogether.

Why should I choose a pension?

Ian Futcher, financial adviser at Quilter, said that when it comes to saving for retirement, there’s “really only one appropriate option” – and that is a pension.

He added: “Pensions come with benefits that ISAs simply cannot match, specifically the additional boost from government tax relief, and if saving via your workplace, employer contributions too.

“As a result, to achieve the same level of pot, the burden on you is far less if you are saving into a pension compared to an ISA.

“Furthermore, pensions provide you with much more headroom for saving, with an annual limit of £60,000 compared to £20,000 for ISAs.

“While this may not seem like a huge amount, in the event of any large windfalls or inheritances, pensions give you a better change to save for later life.”

If you were to invest a £10,000 lump sum as a basic-rate taxpayer, and you achieved a moderate rate of return on your investments, a pension would leave you nearly £7,000 better off after 20 years, and more than £11,000 after 30 years.

Invest annually via a pension and the result are even greater, as the impact of tax relief helps to compound returns over the years.

Former pensions minister Sir Steve Webb, a partner at investment company LCP, said workplace pensions offer great benefits.

As a legal minimum, an employer who has enrolled a worker earning £10,000 per year or more has to pay at least 3 per cent of a band of “qualifying earnings” into that pension, though many employers will do more than this.

Another attraction of pensions is the tax-free lump sum, Sir Steve added: “25 per cent of the pot can be taken out completely tax-free, so this is money that is not taxed on the way in or the way out.

“There is an additional attraction for people who pay higher-rate tax whilst working which is that they get tax relief on their contributions at their highest marginal rate. If they only pay basic-rate tax in retirement – as most pensioners do – then this provides a further advantage compared with an ISA.”

Are ISAs worth considering?

While an ISA doesn’t offer the same tax relief boost as a pension, withdrawals are not taxed. Mr Futcher said: “Utilising tax-free products is crucial if you are to grow and protect your wealth over the long-term.

“Indeed, when it comes to retirement itself, it will be beneficial to have some of your income in an ISA as these withdrawals are tax free – compared to just 25 per cent of your pension pot up to limit – and as such it is advantageous to use both products in the most tax-efficient manner.”

Helen Morrissey, head of retirement analysis at Hargreaves Lansdown (HL), agreed that both tools should be used together: “It’s certainly not an either/or decision though. Pensions and ISAs can be used together to build a very tax efficient retirement income.”

The fact that you cannot access your savings in a pension until age 55 can be offputting to some people. Those people will likely prefer the freedom that comes with an ISA.

Sir Steve said: “ISAs obviously have the advantage of easier access, whereas a pension cannot be touched until you are 55, but if we are talking about retirement savings then this should not matter too much.

“There is also an issue of ‘governance’, particularly for those who are not confident investors. With a workplace pension, there will be trustees or others who, with the support of professional advisers, will help to make sure that your pension is well run and well invested.

“By contrast, with an ISA you are often on your own in terms of making and reviewing investment choices.”

What about lifetime ISAs?

If you’re under the age of 40, you could also consider a lifetime ISA (LISA), Charlene Young, pensions and savings expert at AJ Bell, said.

A LISA can be opened by anyone aged between 18 and 39. You can use one to save up to £4,000 per year – towards either a first home costing up to £450,000, or retirement – with the government adding a bonus of up to £1,000 a year on top.

Ms Young said: “This lets you have the best of both worlds – a saving bonus and tax-free withdrawals, but only if you’re eligible and stick to the rules.

“You need to be under age 40 when you first open the account, and the £4,000 payment limit counts toward your overall ISA allowance.

“The government will top this up by 25 per cent, but you cannot access it for retirement without hefty withdrawal penalties until you are 60.”

Withdrawals have a 25 per cent penalty unless you have less than 12 months to live and then you retain the bonus with no penalties.

If you die, any LISA money including interest and bonuses is passed on to your beneficiaries without penalty, though it will no longer be in an ISA “wrapper”, and will form part of the estate for inheritance tax (IHT) purposes.

How can I decide?

Whichever approach you decide to take, make sure to seek professional financial advice before choosing, Oliver Loughead, financial planner at RBC Brewin Dolphin, said.

Here are a few things to consider:

• What are you saving for?
• When will you need the money?
• How much money will you need when you retire?
• Have you started saving into a pension?
• Can you benefit from employer contributions?
• How is your money invested?
• Have you maxed out your allowances?