I need about £22k a year, should I withdraw from my pension or ISA?

Q: I am 65. I have about £300,000 in my pension and £300,000 in my ISA. I need to draw about £22,000 a year. Should I take this from my pension or my ISA? I haven't taken anything from the pension yet. I don't get my state pension for another 18 months and I don't earn anything else.

A: Many people who have retired earlier than state pension age will be asking this very question.

It’s often said that taking from an ISA first then your pension is the most tax-efficient approach. However, the reality is more nuanced than that.

Those who advocate the “ISA first then pension” approach do so because any withdrawals you make from an ISA are tax-free. Whereas, when you take money from a pension, usually only the first 25% can be taken tax-free and after that withdrawals are taxed at your marginal rate of income tax.

Until recently, there was a double benefit to the “ISA first” approach. Currently, unspent money in a defined contribution pension can be passed on after your death to your beneficiaries without it being counted as part of your estate for inheritance tax (IHT) purposes.

Therefore, for someone likely to incur an IHT bill on their death, using their ISAs first and trying to avoid withdrawing from their pension would mean they could pass on more of their wealth IHT-free.

However, this second benefit is set to disappear. From 6 April 2027, pensions will be included in the calculation of your estate for Inheritance Tax (IHT) purposes.

• Read: What can we expect in the Autumn Budget?

What’s more, the idea that withdrawing from ISAs first is always more tax-efficient is not true. That will depend on a person’s individual situation and, for people retiring before state pension age, the opposite may well be the case.

If you retire before state pension age and withdraw money from your ISAs, you will not be using any of your £12,570 annual tax-free personal allowance (unless you have income from other sources) so it will essentially be wasted.

Once you have used up the funds in your ISA and begin taking money from your pension, you will be able to take up to 25% of the pension tax-free (typically up to a maximum of £268,275).

However, after that, any money you take from the pension will be subject to income tax and, at this point, you will probably already be receiving the state pension (currently £11,973 a year).

This means it’s likely you will have to pay income tax on the pension withdrawals as they will take you over the £12,570 personal allowance.

In this situation, if you were receiving the full state pension (£11,973 a year) and then took another £10,027 from your pension to give you an income of £22,000 a year, then you would be paying around £1,900 in income tax each year.

Therefore, if you think you are likely to need to draw on both your ISAs and your pension, it may be better to take some money from your pension during the period in which you have no other income. This will mean you can make the most of your tax-free personal allowance in those years.

Once you start receiving the state pension, you could switch to drawing down from your ISAs if you want to keep your income below the tax-free personal allowance.

One other factor to bear in mind is whether you might want to contribute to your pension again in future. In this scenario, it seems unlikely however, if someone did want to contribute to their pension again, it may be better to leave the pension untouched. Once you start taking money from the pension, the maximum amount you can contribute and still get tax relief may drop to £10,000 per year.

Please remember that this is not individual tax advice. Being tax-efficient in retirement is a complicated area and will depend entirely on an individual’s circumstances, so for many people it would be helpful to speak to a specialist tax adviser.

If you’ve got a burning question you want to ask, why not drop us a line? Ask us your question.

• Read: What can we expect from the Autumn Budget?
• Read: 6 'Steady Eddies' for a stress-free retirement
• Read: 5 IHT mistakes that could cost you thousands

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Eligibility to invest in a pension and tax treatment depends on personal circumstances and all tax rules may change in the future. Withdrawals from a pension product will not be possible until you reach age 55 (57 from 2028). This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.