Both pensions and ISAs offer a tax-free environment on the investment returns which are generated, but pension savings offer the great additional advantage that contributions benefit from up-front tax relief on contributions equal to the investor's marginal rate of tax.
Consequently, gross contributions of £10,000 cost a higher rate taxpayer £6,000 and the compounding benefit of this boost to capital is maintained until the fund is realised. In addition, when the fund is realised, 25% of the value can usually be drawn in the form of tax-free cash.
However, when income is drawn from the pension savings, whether in the form of annuity or income drawdown, this is subject to income tax at the recipient's marginal tax rates. By contrast, the income from an ISA is tax-free and capital can be withdrawn at any time, again with no tax liability. The ISA also wins in the event of the death of the investor, when the rate of inheritance tax payable will be 40%, whereas the corresponding rate for pension funds is usually 55%.
So, is it possible to have the best of both worlds? An arrangement which might be considered, particularly by those who expect to be subject to higher rate tax in retirement, would be to draw down income from the pension fund as from age 55 and use this to invest in ISAs. The drawdown income would be taxable but the ISA income, also benefiting from tax-free growth, would not.
This could provide a useful increase in net income over time and the tax rate on death would be lower. To maximise the benefit, ISAs could be bought for both partners in a relationship and consideration might also be given to purchasing junior ISAs for grandchildren.