ISA or pension? Where to take money from first in retirement

It is a nice problem to have. You’re on the cusp of retirement and have two healthy savings pots: your ISA and your pension. They are a similar size, and both house a mixture of investments and cash. Which one should you access first? 

This dilemma has been thrust into the spotlight by government changes. Currently, most pension funds are not subject to inheritance tax (IHT), whereas ISAs are. As such, many wealthy retirees spend their ISAs first with a view to passing on their unused pensions when they die. 

• Read more: Inheritance Tax changes

Next year, however, the rules are changing. From 6 April 2027, pensions will count towards a person’s ‘estate’ for IHT purposes, in much the same way as other savings pots.

This could have significant consequences. For many people, a pension is second only to their house in value. Bringing pensions into the scope of IHT, therefore, is expected to increase the number of families facing a tax bill. The government estimates that around 10,500 new estates - or 1.5% of UK deaths each year - will be pulled into paying IHT. Another 38,500 estates will pay more IHT than they would have done under the old system.

• Learn more about our award-winning Stocks and Shares ISA

The change also raises the spectre of double taxation. If someone dies after turning 75, their pension could be subject to both IHT and income tax for their beneficiaries. 

For some people, therefore, the "fund it first, spend it last" approach to pensions needs a rethink. These three questions will help you decide whether you're one of them.

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1. What is best for you?

It is easy to get bogged down in complicated IHT calculations. Before you start fretting about your legacy, however, you need to think about the here and now. How can you reduce your tax bill in your lifetime?

There is a strong temptation to rely on tax-free money early in retirement - either from your ISA or from the tax-free part of your pension. Doing so can lead to more tax in the long run, however.

This is because, every year, most people get a personal allowance of £12,570. This is the amount you can earn without paying any income tax. If you subsist solely on tax-free money, you are not making use of this valuable perk. As such, it often makes sense to take a mixture of tax-free and taxable income.

• Read more: The best (and worst) ways to take your tax-free cash

The logic breaks down when you start to receive the State Pension, as payments from the government will eat up your personal allowance. If you’re younger, however, it can be very powerful. Imagine you retire at 60. Over the next six years, you could potentially withdraw more than £70,000 from the taxable part of your pension without paying any income tax, simply by using your personal allowance each year.

Paying less tax in your own lifetime should, in turn, leave more for your beneficiaries. More importantly, though, it reduces the risk of running out of money yourself. That is easy to lose sight of when your legacy becomes the focus.

IHT shouldn’t drive every decision. The new rules might tempt people to gift money while they are alive, for example, hoping it will fall outside their estate by the time they die. There are various ways to do this tax efficiently - but before you start, you need to carefully assess how much money you will need yourself. Depending on when you retire, you could have decades ahead of you, and no one knows what kind of care they will require later in life.

• Read more: 8 key questions answered on IHT gifting allowances

2. What is best for your beneficiaries?

Once you’ve assessed your own tax situation - and your own financial needs - it’s time to think about your beneficiaries. Would it be better for them to inherit an ISA or a pension?

Unfortunately, there isn’t a neat answer to this. It depends on a wide range of factors, including whether you leave your money to a spouse or somebody else; whether you die before or after age 75; and whether your beneficiaries are basic, higher or additional-rate taxpayers.

The best strategy depends heavily on your circumstances, and personalised financial advice can be valuable. A good starting point, though, is to understand the basic tax treatment of inherited ISAs and pensions from April 2027.

ISA

• Subject to IHT, unless left to a UK resident spouse
• No income tax on withdrawals
• Loses its tax-free wrapper, unless inherited by a spouse

Pension

• Subject to IHT, unless left to a spouse
• Subject to income tax on beneficiaries if you die after age 75
• It may be possible for the fund to remain inside a pension wrapper after you die, allowing continued tax-efficient investment growth, and control of income tax on withdrawals

There are a couple of things to pick out here. First, IHT does not apply between spouses. If you leave money to your husband, wife, or civil partner, they won’t have to pay IHT. Second, if you die before age 75, your pension will not be subject to income tax. This makes comparisons between ISAs and pensions somewhat more straightforward.

Things get more complicated if you die after turning 75 and leave money to, for example, your children. In this scenario, both inheritance tax and income tax could come into play.

Imagine you are a basic-rate taxpayer and want to spend £10,000 on a new car. Should you take that money from your ISA or your pension if your priority is to leave as much as possible to your child?

The first key point to note is this: to spend the same amount, you usually need to withdraw more from a pension than from an ISA because some of the pension withdrawal is lost to income tax.

• ISA: You withdraw £10,000. Your child therefore inherits £10,000 less inside the ISA. After 40% inheritance tax, this means they miss out on £6,000.
• Pension: To spend £10,000, you must withdraw £12,500 from your pension. This means your child inherits £12,500 less inside the pension. After 40% inheritance tax, this means they miss out on £7,500. But when they withdraw the inherited pension, they must also pay basic-rate income tax, meaning they ultimately miss out on £6,000.

In this scenario, the outcomes for ISAs and pensions are broadly the same. However, if your child is a higher or additional rate taxpayer, the picture shifts. They would rather receive the ISA than the pension in the scenario above, as they would end up with a bigger sum post tax.

That said, the timing of withdrawals also matters. An inherited pension can remain invested within its tax-efficient wrapper, potentially allowing growth to continue for years before beneficiaries access the money.

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3. What tax relief have you already banked?

Everything we've discussed so far assumes your ISA and pension are already funded. If that's the case, the first two questions matter most to you.

If you’re still in the saving stage, however, you might be wondering whether it still makes sense to pay into a pension at all, or whether you should prioritise your ISA instead.

To answer this, you need to look across the entire life cycle of a pension. In other words, to think about the tax relief when the money goes in, as well as the tax paid on the way out. The numbers show that pensions often still come out on top, even if some money is eventually lost to IHT and income tax.

In the table below, the green cells show scenarios where you would pay less tax by contributing to a pension than you otherwise would have done.

Overall tax outcome or a pension (assuming 40% inheritance tax is due)

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Tax treatment depends on individual 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.