ISA or pension: scenarios for age 30, 40 and 50

A key consideration for anyone building their long-term wealth is whether to save into an ISA or a pension.

Both are tax-efficient ways to save as you won't pay UK tax on growth in your investments.

But having wrestled with this dilemma over several decades, I would highlight three crucial differences in deciding how you want to balance your contributions:

1. Tax relief: pensions benefit from tax relief on contributions. For example, for a higher-rate taxpayer, £1,667 paid into a pension can effectively cost £1,000 after 40% income tax relief, assuming the full contribution qualifies for higher-rate relief.
2. Withdrawals: money accrued in ISAs can be withdrawn without paying income tax. Money accrued in a pension is subject to the relevant rate of income tax you’re paying when you withdraw (although 25% can be taken free of income tax).
3. Age of access: pensions are not accessible until age 55 (rising to 57 on 6 April 2028) whereas ISA money can be withdrawn at any age.

We have run the numbers on different scenarios to help establish the benefit of each route. A crucial factor in determining outcomes is the income tax rate you pay when contributing - and when you withdraw. Our tables account for this.

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Our comparison is between ISAs and the most common type of workplace pensions - defined contribution pensions. Self-invested pension plans, or SIPPs, have the same tax advantage but it works a little differently. We explain this below.

I should add that there are many other differences between pensions and ISAs, such as the amounts you can contribute (£60,000 each year for most people into a pension vs £20,000 into an ISA each year). Our detailed ISA or SIPP page has more information.

Today, we are focusing on the pound-for-pound impact of different tax rates on money in and money out.

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The maths

For simplicity, we have set out three basic scenarios for those aged 30, 40 and 50. We start with the same £1,000 cost to you, the saver. £1,000 goes into the ISA, while tax relief means a larger gross amount can go into the pension.

We assume your money grows at 6% a year after charges, and that you withdraw it at age 60. Investment returns are not guaranteed and the value of your money will rise and fall.

Under current rules, you can usually take up to 25% of your pension tax-free, subject to your available lump sum allowance, which is £268,275 for most people. We have therefore factored that into the calculations.

We have focused only on the most common scenarios to lighten the load on the table. The advantage would improve for those paying the 45% additional income tax rate, applied on earnings above £125,140. 

Invest at age 50, withdraw at age 60

The table below shows that putting £1,000 into an ISA or pension at age 50 results in very different outcomes based on the variable of income tax rates. It underlines how much the tax treatment of pensions can matter – even when the underlying investment performs exactly the same.

Take our higher-rate taxpayer who remains a higher-rate taxpayer in retirement. Their £1,000 of take-home pay is equivalent to £1,667 going into the pension once 40% tax relief is taken into account. After 10 years of 6% annual growth, that is worth £2,985 before tax.

On withdrawal, 25% can be taken tax-free. If the rest is taxed at 40% - that leaves £2,089 in their pocket. The same £1,000 invested in an ISA grows to £1,791. The pension therefore offers a £298 advantage.

In this scenario, a pension largely defers income tax rather than avoiding it. With an ISA, you pay income tax before the money goes in; with a SIPP, you receive tax relief on the way in but pay income tax when you take the money out. If your tax rate is the same at both points, those effects broadly cancel out. The pension’s advantage comes from the 25% that can be taken tax-free.

The numbers become considerably more attractive if our higher-rate taxpayer becomes a basic-rate taxpayer in retirement. The same £1,667 pension investment grows to the same amount, but this time only 20% is due on the taxable portion. They are left with £2,537, compared with £1,791 from the ISA – a difference of £746.

This is where pensions really come into their own. Our saver has effectively received tax relief at 40% when putting the money away but pays just 20% on three-quarters of it when taking it out.

Finally, consider someone who is a basic-rate taxpayer both today and in retirement. Their £1,000 of take-home pay translates into £1,250 in the pension. After 10 years, and after allowing for 20% tax on three-quarters of the pension, they are left with £1,903, £112 more than the ISA.

For illustration, we assume the full pension contribution qualifies for tax relief at the rate shown and the entire taxable portion of the withdrawal is taxed at the rate shown. We ignore National Insurance, employer contributions and other income.

We have to assume pension rules will remain the same, simply because making decisions based on ‘what ifs’ is problematic. Even if the 25% tax-free withdrawal were removed, the pension advantage over an ISA would remain substantial if you drop down an income tax band in retirement.

The tables below show what happens over 20 years and 30 years, based on the same assumptions - 6% annual returns after charges and that rules remain the same.

Age 40 to 60 (20 years)

For illustration, we assume the full pension contribution qualifies for tax relief at the rate shown and the entire taxable portion of the withdrawal is taxed at the rate shown. We ignore National Insurance, employer contributions and other income.

Age 30 to 60 (30 years)

For illustration, we assume the full pension contribution qualifies for tax relief at the rate shown and the entire taxable portion of the withdrawal is taxed at the rate shown. We ignore National Insurance, employer contributions and other income.

It is, perhaps, worth underlining the principles again:

• ISA: You pay tax before investing, but never again.
• Pension: You invest before tax, and because a quarter comes out tax-free, only 75% of the pot is ever exposed to income tax.

It is this 25% tax-free amount that gives pensions the edge over ISAs for higher-rate taxpayers even if they remain higher-rate taxpayers in retirement.

This leaves us with a final consideration…

SIPP vs company pension

A company pension is convenient and employer contributions improve its appeal. Under automatic enrolment rules, employers generally have to contribute at least 3% of qualifying earnings, and many employers offer more generous terms. For that reason, a company pension tends to be a bedrock of a retirement saving plan. A SIPP, however, is a great place to consolidate money from old work pensions and can be used for additional contributions.

A further benefit is that if your contributions are made through salary sacrifice, you can also save National Insurance, although the saving is generally smaller than the income tax benefit.

With salary sacrifice, you agree to give up part of your salary and your employer pays the equivalent amount into your pension. Because the sacrificed salary is not paid to you, you do not pay income tax or employee National Insurance on it.

Self-invested personal pensions (SIPPs) work slightly differently. With most SIPPs, you pay money into the pension from your bank account after tax and the pension provider claims basic-rate tax relief from the government on your behalf.

For example, if you pay £800 into a SIPP, the government adds £200, giving you a £1,000 pension contribution. If you are a higher-rate taxpayer, you can claim a further £200 of tax relief from HMRC. Assuming the whole contribution qualifies for relief at 40%, the £1,000 pension contribution therefore costs you £600 overall.

• Read: Self-employed and pensions: how to get started with a SIPP

There can be other tax benefits, too. Pension contributions can reduce the income figure used to assess entitlement to certain benefits and allowances. For some higher earners, this can help them retain more Child Benefit or qualify for government-funded childcare that might otherwise be lost.

In addition, some people use pension contributions to avoid drifting into higher rates of income tax and particularly the ‘60% rate’ at £100,000. More is explained here: Don’t pay 60% tax unnecessarily – use your SIPP before 5 April

A reminder of income tax band rates (different bands apply in Scotland)

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• Read: ISA or pension? Where to take money first in retirement
• Read: 3 reasons why retirement is cheaper than you think
• Read: Kick-start your pension with this investment idea

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. SIPP eligibility and tax treatment depends on individual circumstances and tax rules may change. You cannot normally access money in a pension until 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.