Why pensions are still the best place to save for your retirement in 2025
- colinslaby
- Jan 22
- 6 min read
With the planned inclusion of pensions in the estate value for Inheritance Tax (IHT) starting in 2027, many individuals may begin to question whether pensions remain the most advantageous option for saving for retirement. This concern is particularly relevant for those who are keen to maximise their contributions as the end of the tax year approaches.
Despite these changes, the majority of people will likely still find that the answer is "Yes"—pensions will continue to be the most tax-efficient vehicle for retirement savings compared to alternative options like ISAs or other investment accounts. Pensions offer significant tax relief on contributions and potentially tax-free growth on investments, making them an attractive choice for long-term savings.
Moreover, even individuals who do not anticipate needing their pension funds for their own retirement income—perhaps those who have alternative sources of income or who plan to downsize—may still benefit from contributing to a pension.
This is because leaving a larger pension pot to heirs can often result in a more substantial inheritance than if the same funds were invested elsewhere. With strategic planning and careful consideration, saving into a pension can help ensure that future generations receive a more significant financial legacy, despite the potential tax implications introduced in 2027.
Pensions v ISA for retirement
To evaluate the effectiveness of pension savings, we have compared them to their closest tax-privileged alternative – the Individual Savings Account (ISA).
Both pensions and ISAs offer protection from income tax and capital gains tax. However, the main difference lies in the tax relief on contributions and the tax-free cash available upon withdrawal.
This provides a strong argument for prioritising pension contributions over ISAs when the goal is to generate retirement income. The only individuals who might be worse off are those taking withdrawals that do not include tax-free cash and who are taxed at a higher rate on withdrawals than the tax relief they received on contributions. However, this situation is relatively uncommon; most individuals will likely pay a lower tax rate during retirement than they did while working.
For example, a gross pension contribution of £16,667 would cost a higher-rate taxpayer £10,000. Ignoring any growth, the amount available upon withdrawal in retirement (even if the individual remains a 40% taxpayer) would be £11,667. This consists of £7,500 in income after tax plus £4,167 in tax-free cash. In contrast, the same £10,000 invested in an ISA would still amount to £10,000 upon withdrawal. Consequently, the total spendable amount from the pension, after all taxes, is 16.67% higher than that from an ISA, solely due to the different tax treatments.
The table below looks at a sample of returns where the rate of tax relief on contributions is greater or equal to the income tax on withdrawals:
Personal Tax Rate When paid in | Personal Tax Rate on withdrawal | Gross amount invested in pension | Pension Return after tax | ISA Return | % pension over ISA |
45% | 40% | £18,182 | £12,727 | £10,000 | 27.27% |
45% | 20% | £18,182 | £15,455 | £10,000 | 54.55% |
40% | 40% | £16,667 | £11,667 | £10,000 | 16.67% |
40% | 20% | £16,667 | £14,167 | £10,000 | 41.67% |
20% | 20% | £12,500 | £10,625 | £10,000 | 6.25% |
These figures are based on headline rates of tax. The true effective rates of income tax in retirement are likely to be much lower.
Pensions v ISA at death
Pensions have long been recognised as one of the most tax-efficient means of saving for retirement. This status is expected to continue even with the forthcoming changes regarding inheritance tax (IHT) applicable to unspent pension funds. Starting in April 2027, pension death benefits will be subjected to inheritance tax unless they are bequeathed to a spouse or civil partner. This new regulation brings pensions in line with Individual Savings Accounts (ISAs), which are also treated similarly under IHT rules.
However, there are significant differences in how pensions and ISAs are taxed. In the case of pensions, inheritance tax will be deducted from the pension pot before any distribution to beneficiaries. If the original scheme member passed away at the age of 75 or older, the remaining balance in the pension after IHT is taken out will be further taxed at the recipient’s marginal rate of income tax. This raises questions about 'double taxation'—specifically, whether this dual layer of tax could dissuade individuals from saving for retirement beyond their workplace pension schemes.
To illustrate this concept, let’s consider a practical example involving a higher rate taxpayer who makes a gross pension contribution of £16,667. The actual out-of-pocket cost for this taxpayer is £10,000, thanks to the tax relief provided on pension contributions. If the scheme member dies before drawing any income from the pension, and assuming there is no nil-rate band available, the funds in the pension will be subject to inheritance tax at a rate of 40%. Consequently, the amount left for beneficiaries would be £10,000 after IHT is deducted.
However, if the scheme member dies after reaching the age of 75, the situation becomes more complex. In this scenario, the beneficiary will first incur a 40% IHT tax deduction, leaving them with £10,000. If they then decide to draw an income from the pension, they will be taxed again at their marginal income tax rate. For example, should the beneficiary fall into the 20% income tax bracket, they will be left with £8,000 after the additional income tax is levied on the distributed amount.
In comparison, if this individual had invested the same amount into an ISA, the post-tax net benefit would be calculated differently. After IHT, the £10,000 from the ISA would be reduced further, potentially worth only £6,000, making it 25% less beneficial than the pension distribution in the earlier scenario. Even for a beneficiary who is a higher rate taxpayer and pays 40% tax, the net amount available to spend from the pension would still match the ISA's net worth of £6,000.
Furthermore, it's crucial to note that if the scheme member dies before they reach the age of 75, the beneficiaries would not face any income tax liability on benefits drawn from the pension, unless the payment exceeds the new Lifetime Savings and Distribution Benefits Allowance (LSDBA) limits set to take effect. This added complexity stresses the importance of understanding the tax implications of different saving vehicles for retirement.
The table below considers the outcomes for a sample of scenarios based on a net cost to the saver of £10,000 and where the scheme member dies aged 75 or older.
Tax Rate when paid in / tax rate on withdrawal | Gross amount invested in pension | Pension net of IHT | Pension net of income tax | ISA net of IHT | £ increased return in pension |
45% / 40% | £18,182 | £10,909 | £6,545 | £6,000 | 9.09% |
45% / 20% | £18,182 | £10,909 | £8,727 | £6,000 | 45.45% |
40% / 40% | £16,667 | £10,000 | £6,000 | £6,000 | 0% |
40% / 20% | £16,667 | £10,000 | £8,000 | £6,000 | 33.33% |
20% / 20% | £12,500 | £7,500 | £6,000 | £6,000 | 0% |
Most clients who fund pensions for wealth transfer purposes are typically higher earners. They are likely to benefit from tax relief at either 40% or 45%. As a result, in most cases, the pension will enhance the inheritance for the beneficiary, even after accounting for both inheritance tax (IHT) and income tax.
An exception occurs when the beneficiary is subject to income tax at a rate higher than the relief received on the contributions. This situation may arise, for example, if the death benefit is paid as a lump sum, resulting in part of the death benefit being taxable at 45%.
Fortunately, most modern pension schemes offer inherited drawdown options. This allows beneficiaries to manage their withdrawals carefully to stay below significant tax thresholds. It is crucial to ensure that death benefit nominations are current, enabling adult children to access drawdown options rather than only a lump sum payment.
Summary
The introduction of Inheritance Tax (IHT) on pensions has created a more equitable landscape for taxation, as it aligns pensions with all mainstream tax wrappers that are subject to IHT. This change is significant because it means that individuals who have previously accumulated pension wealth with the intention of passing it on to their beneficiaries now face a much greater IHT liability than they had originally expected. This could lead to unintended financial consequences for those individuals and their heirs, as their estate planning strategies may now need to be reassessed.
Despite this alteration in tax treatment, it is crucial to understand that this should not act as a deterrent for individuals who are currently saving into their pensions. In fact, pensions continue to be recognized as one of the most tax-efficient long-term savings vehicles available for the vast majority of clients. They offer valuable tax relief on contributions and potential growth, making them particularly advantageous for those planning for retirement. Additionally, for individuals considering wealth transfer, pensions can still be an effective way to provide for future generations, despite the new IHT implications. Overall, the benefits of investing in a pension remain significant, and it is advisable for individuals to continue prioritizing pension savings as part of their overall financial strategy.
