ISA or pension – which should I take first?

You may have heard that it’s more tax efficient to draw money from Individual Savings Accounts (ISAs) before pensions in retirement, and that personal pensions are something taken at a specific retirement age, such as an employer’s ‘retirement date’ or when the state pension kicks in.

While this strategy may work for some people, many of those retiring before the state pension age could end up with a bigger tax bill by only withdrawing income from ISAs. This may be beneficial under current rules as far as inheritance tax (IHT) on early death goes, but these benefits will be impacted by the proposed changes to IHT on pensions from April 2027. By withdrawing income solely from ISAs, retirees also run the risk of not utilising multiple years of their tax-free personal allowance.

A guide to income in retirement

Find out your retirement income options and the steps you may need to take in our comprehensive guide.

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Our case study shows that someone ceasing work at age 60 could potentially save tens of thousands of pounds in tax by drawing some of their income from pensions as soon as they retire, but in a controlled way. Read on to find out why.

How ISAs and pensions are taxed

The reason why it’s often considered better to deplete ISAs before pensions in retirement is due to the way they’re taxed.

Although ISAs don’t provide tax relief on contributions, withdrawals are completely tax free*. Personal pension contributions benefit from income tax relief, but when you come to draw an income from the pension, usually only 25% can be taken tax free and the rest is taxed at your marginal rate of income tax.

Under the current rules, another key difference between ISAs and pensions is the way they’re treated for IHT purposes upon death. The value of your ISAs will be included in your estate for IHT purposes, whereas pensions currently usually sit outside of your estate. However, the chancellor announced in the 2024 Autumn Budget that unused pension funds and death benefits will likely be included within the estate from 2027.

The theory is that by drawing money from ISAs first, you’ll benefit from more tax-efficient retirement income and, currently, pass on a bigger pot of money to your loved ones. The changing rules around IHT and pensions could potentially have an impact your retirement and succession plans, so you may wish to speak to a financial or tax adviser.

The role of the personal allowance

In reality, things are not quite so clear-cut. The approach that’s right for you will depend on your individual circumstances and what you want to achieve with your money.

Drawing money from ISAs first could also make sense if you’re already receiving your state pension. The full state pension is just under £12,000 a year for the current tax year. This pretty much uses up the £12,570 tax-free personal allowance. If you made personal pension withdrawals on top of this, you could pay tax on the lion’s share of your private pension income. You may also wish to leave your pension untouched if you think you’ll want to contribute to it again in the future. Once you start drawing taxable income from a defined contribution pension, the maximum amount you can contribute each year and still get tax relief falls to £10,000.

On the other hand, if you retire earlier than the state pension age, taking some pension income as soon as you retire could prove tax efficient. The £12,570 personal allowance can’t be carried forward from one tax year to the next, so if you were to draw all your income from ISAs, your personal allowance would effectively be wasted. Over time, failing to use your personal allowance could result in a bigger-than-expected tax bill.

Let’s imagine you cease work at age 60 and decide to draw all your income from ISAs until the state pension kicks in at age 67. You won’t pay any income tax during those seven years because ISA withdrawals are tax free. However, depleting your ISAs means the proportion of tax-free income you can draw in later years could be considerably smaller than if you’d accessed your pension earlier. The case study below illustrates the potential tax savings that could be made by taking some pension income from age 60.

Case study

Please note that these calculations do not take into account investment growth, charges or inflation. We also assume that the income tax personal allowance and tax rates stay the same for the entire period.

Andrea retires at age 60 with £245,000 in an ISA and £950,000 in a personal pension, of which 25% of the value is available as a tax-free lump sum (up to the standard allowance of £268,275). This tax-free amount can be drawn:

• In full or in partial payments
• flexibly with taxable income or without taxable income

Andrea wants to be able to spend £35,000 a year in retirement.

She plans to make tax-free withdrawals from her ISA until it runs out at age 67, after which she will draw her state pension and start accessing her personal pension.

Andrea won’t pay any income tax in the first seven years of retirement, but between the ages of 67 and 74, she’ll pay over £27,000 in tax.

Following a recommendation by her financial adviser, Andrea’s new strategy sees her:

• Drawing £16,000 a year from her personal pension from age 60. Of this, £4,000 is pension tax-free cash and £12,000 of taxable income falls within the personal allowance. The remaining £19,000 a year comes from tax-free ISA withdrawals.
• Drawing her state pension from age 67. She also draws £16,000 a year from her ISA, and £8,200 a year from her personal pension, of which £2,050 is tax-free cash and £6,150 is taxable income.

Andrea pays no income tax in the first seven years of retirement, and between the ages of 67 and 74 her tax bill is just over £7,700. By drawing some of her pension from age 60, she saves nearly £20,000 in tax.d between the ages of 67 and 74 her tax bill is just over £7,500. By drawing some of her pension from age 60, she saves nearly £20,000 in tax.

Objective	Drawing an annual pension income of £35,000
	Original Situation	Taking some pension from age 60
Age 60 to 67	Draw £35,000 a year from ISA	Draw £16,000 a year from personal pension (£4,000 tax-free cash, £12,000 within personal allowance) Draw £19,000 a year from ISA
Situation at age 67	ISA value = £0 Pension value = £950,000 Tax paid = £0	ISA value = £112,000 Pension value = £838,000 Tax paid = £0
Age 67 to 74	Receive £11,973 a year from state pension Draw £27,000 a year from personal pension (25% tax free) Tax paid = £3,931 a year	Receive £11,973 a year from state pension Draw £16,000 a year from ISA Draw £8,200 a year from personal pension (25% tax-free) Tax paid = £1,111 a year
Situation at age 74	ISA = £0 Pension value = £761, 000 Total tax paid = £27,514 a year	ISA = £0 Pension = £780,600 Total tax paid = £7,774 a year
Total tax paid	£27,514	£7,774
Tax saving	£19,740

Source: RBC Brewin Dolphin. Calculations do not take into account investment growth, charges or inflation.

Based on the above scenario, Andrea would still have some pension tax-free cash available at age 74.

Next steps

Deciding how to draw a tax-efficient and sustainable retirement income can be complicated, and that’s where getting some financial and/or tax advice comes in. At RBC Brewin Dolphin, we can build a plan that is tailored to your individual circumstances, and help you feel confident you’re doing the right thing with your money.

*Withdrawals from Lifetime ISAs before age 60 (that aren’t for a first property purchase) are subject to a 25% penalty.

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The value of investments, and any income from them, can fall and you may get back less than you invested. This does not constitute tax or legal advice. Tax treatment depends on the individual circumstances of each client and may be subject to change in the future. You should always check the tax implications with an accountant or tax specialist. Information is provided only as an example and is not a recommendation to pursue a particular strategy.

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