Pensions vs. ISAs: Do Pensions Remain the Best Retirement Savings Option?

For most people, the answer remains a resounding "Yes." Pensions continue to be the most tax-efficient way to save for retirement when compared to other tax wrappers. Even individuals who do not anticipate needing their pension for income and intend to pass their pension wealth to future generations are still likely to provide a greater inheritance by saving into a pension.

Pensions vs. ISAs for Retirement Savings

To assess the effectiveness of pension savings, we compare them to ISAs, their closest tax-efficient alternative. Both pensions and ISAs safeguard savings from income tax and capital gains tax, but the crucial difference lies in tax relief on contributions and the availability of tax-free cash upon withdrawal.

This distinction strongly favours funding pensions before ISAs when retirement income is the objective. Only in cases where withdrawals contain no tax-free cash and are taxed at a higher rate than the relief received on contributions would an individual be at a disadvantage. However, such scenarios are uncommon, as most people will have a lower tax rate in retirement than during their working years.

For example, a gross pension contribution of £16,667 would cost a higher-rate taxpayer just £10,000 after tax relief. Assuming no investment growth, even if the individual remains a 40% taxpayer in retirement, they would receive £11,667 upon withdrawal (£7,500 after tax plus £4,167 in tax-free cash). By contrast, an ISA investment of £10,000 would remain £10,000 upon withdrawal. As a result, the net spendable amount from the pension is 16.67% higher than from an ISA due to its tax advantages.

The Impact of IHT on Pensions from 2027

From April 2027, pension death benefits will be subject to IHT unless left to a spouse or civil partner. This aligns pensions with ISAs, which are already subject to IHT. However, where they differ is in how taxation is applied:

• Pension funds will first have IHT deducted, and if the original scheme member was 75 or older at death, any remaining balance will be subject to income tax at the beneficiary's marginal rate.
• While this "double" taxation raises concerns, pensions often still provide superior financial outcomes compared to ISAs.

Consider a higher-rate taxpayer making a £16,667 gross pension contribution at a net cost of £10,000. If unwithdrawn at death, IHT at 40% would reduce the pension to £10,000. If the beneficiary then withdraws the funds and pays 20% income tax, they would receive £8,000 net. Comparatively, a £10,000 ISA after IHT would leave just £6,000. Even if the beneficiary were a 40% taxpayer, both the pension and ISA would result in £6,000 of spendable income, but the pension provides greater flexibility.

For deaths before age 75, there is no income tax on withdrawals, unless exceeding the new Lump Sum Death Benefit Allowance (LSDBA), further strengthening the case for pensions over ISAs.

Planning Considerations for Inheritance

Most individuals using pensions for wealth transfer purposes are higher earners and receive tax relief at 40% or 45%. This means, in most cases, pensions will still provide a greater inheritance than ISAs, even after both IHT and income tax deductions.

The main exception occurs if the beneficiary's income tax rate exceeds the tax relief received on contributions, such as when a lump sum payment pushes part of the inheritance into the 45% tax bracket. However, modern pension schemes often allow inherited drawdown, enabling beneficiaries to manage withdrawals strategically and minimise tax liabilities. To maximise these benefits, it is crucial to keep death benefit nominations up to date and ensure adult children can opt for drawdown instead of a lump sum.

Conclusion

The introduction of IHT on pensions from 2027 has largely levelled the playing field among tax-advantaged savings vehicles, as all mainstream tax wrappers will now be subject to IHT. However, for those saving for retirement or planning to pass down wealth, pensions remain the most efficient choice due to their upfront tax relief, tax-free cash advantages, and potential for strategic drawdown to optimize tax efficiency. While IHT changes introduce new complexities, careful planning can help mitigate the impact and ensure pensions continue to be the best vehicle for long-term savings and inheritance planning.

To discuss your best savings and retirement options for your lifestyle and goals, speak with your TaxAssist Accountant or with Financial Planning by TaxAssist.