Pension vs ISA for Retirement Income: Which Should You Draw From First?

When you reach retirement, you may find yourself with savings in both a pension and an ISA. One of the most important decisions you'll face is which pot to draw from first—and in what order. This choice can have significant implications for your tax bill, the longevity of your savings, and even how much you can pass on to your family.

In this guide, we explore the key differences between pensions and ISAs in retirement, and examine the factors that might influence your withdrawal strategy.

Understanding the Key Differences

Before deciding which account to tap first, it helps to understand how pensions and ISAs differ in retirement:

Pension Characteristics

• Tax on withdrawals: After taking your 25% tax-free lump sum (pension commencement lump sum), further withdrawals are taxed as income
• Inheritance tax: From April 2027, unused pension funds will form part of your estate for IHT purposes (see our guide to pension IHT changes from 2027)
• Death benefits: If you die before 75, beneficiaries typically receive the fund tax-free (pre-2027 rules); after 75, they pay income tax on withdrawals
• Access: Generally available from age 55 (rising to 57 from 2028)
• Lifetime allowance: Abolished in 2024, though the lump sum allowance (£268,275) still applies

ISA Characteristics

• Tax on withdrawals: Completely tax-free—no income tax on any amount withdrawn
• Inheritance tax: ISAs form part of your estate (unless inherited by a spouse/civil partner)
• Death benefits: Your spouse can inherit your ISA allowance via an Additional Permitted Subscription (APS)
• Access: Available at any age with no restrictions
• Contribution limits: £20,000 per year (2025/26)

The Traditional Approach: ISA First

For many years, conventional wisdom suggested drawing from ISAs first, allowing pension pots to continue growing in a tax-advantaged environment. The logic was straightforward:

• Pensions sat outside your estate for inheritance tax purposes
• Pension death benefits were often more favourable than ISA rules
• Delaying pension access meant more time for tax-free growth

However, this approach has evolved significantly, particularly with the announcement of changes to pension inheritance tax rules from April 2027.

The 2027 Pension IHT Changes: A Game Changer

From April 2027, unused defined contribution pension funds will be included in your estate for inheritance tax purposes. This fundamental change has caused many people to reconsider the 'pension last' strategy.

Key implications include:

• Estate planning: Pensions will no longer automatically pass outside your estate
• Double taxation risk: Beneficiaries could face both IHT on the pension pot and income tax on withdrawals
• Strategy shift: Some advisers now suggest considering pension withdrawals earlier in retirement

When Drawing From Your Pension First Might Make Sense

Several scenarios might favour accessing pension savings before ISAs:

1. Maximising Your Personal Allowance

If you have low or no other income in early retirement (before state pension begins), you could withdraw pension income up to your personal allowance (£12,570) tax-free. This strategy effectively converts taxable pension funds into tax-free income.

2. Avoiding Higher Rate Tax Later

Once your state pension begins, your taxable income increases. By drawing pension income in earlier years, you might stay within the basic rate tax band and avoid pushing yourself into higher rate territory later.

3. The 2027 IHT Changes

If you're concerned about inheritance tax and want to reduce the size of your pension pot before April 2027, you might consider making planned withdrawals. Some people use this strategy to gift money to family members, potentially reducing their estate further if they survive seven years.

4. Large Pension Pots

Those with substantial pension savings might find that keeping funds in a pension until death results in significant IHT liability. A phased withdrawal strategy could help manage this.

When Drawing From Your ISA First Might Make Sense

Conversely, there are situations where accessing ISA funds first remains advantageous:

1. Tax-Free Flexibility

ISA withdrawals don't count as income, so they won't affect your tax band, trigger the high income child benefit charge, or interact with means-tested benefits.

2. Preserving Pension Tax-Free Cash

If you haven't yet taken your 25% tax-free lump sum, keeping it within the pension allows the entire pot (including that 25%) to continue growing. Once taken, that money stops benefiting from pension tax advantages.

3. Death Before 75

Under current rules (pre-2027), if you die before 75, your pension can pass to beneficiaries completely tax-free. This makes pensions attractive for estate planning—though the 2027 changes will modify this benefit.

4. Married Couples

ISAs can be transferred to a spouse via APS without affecting their own ISA allowance. If you die first, your spouse keeps the tax-free wrapper. This can be part of an effective estate planning strategy for couples.

The Blended Approach: Using Both Strategically

Rather than an 'either/or' decision, many people benefit from drawing on both pensions and ISAs in a coordinated way. This approach might look like:

• Use pension withdrawals to fill your personal allowance: Take enough from your pension to use your tax-free personal allowance each year
• Top up with ISA: If you need more income, draw tax-free amounts from your ISA
• Stay within the basic rate band: Avoid drawing so much pension income that you enter higher rate tax territory
• Consider timing: Your income needs and tax position may change throughout retirement

Example: The Tax-Efficient Blend

Consider someone with no other income in early retirement:

• Personal allowance: £12,570
• Pension withdrawal: £12,570 (taxed at 0%)
• Additional income needed: £10,000 from ISA (tax-free)
• Total retirement income: £22,570 with zero income tax

This contrasts with taking £22,570 from the pension, which would result in approximately £1,886 in income tax (20% on the amount above the personal allowance).

Factors to Consider in Your Decision

When deciding on your withdrawal strategy, you might want to think about:

Your Tax Position

• What is your current income from all sources?
• When will your state pension begin?
• Do you have any other taxable income (rental property, part-time work)?
• What tax band are you in now versus what you expect in future?

Your Estate Planning Goals

• How important is leaving money to beneficiaries?
• What is your current estate value relative to the IHT threshold?
• Have you considered the 2027 pension IHT changes?
• Are you married or in a civil partnership?

Your Income Needs

• How much do you need to withdraw each year?
• Is your spending likely to change as you age?
• Do you have emergency funds accessible outside your pension and ISA?

Your Health and Life Expectancy

• Your personal circumstances may influence which strategy suits you best
• Those with health concerns might have different priorities than those expecting a long retirement

Common Mistakes to Avoid

When managing pension and ISA withdrawals, some common pitfalls include:

• Ignoring the personal allowance: Not making use of tax-free income thresholds
• Taking large lump sums: This can push you into a higher tax band unnecessarily
• Forgetting about emergency tax: Initial pension withdrawals may be taxed at emergency rates—you can reclaim overpayments
• Not reviewing annually: Your optimal strategy may change as your circumstances evolve
• Overlooking the money purchase annual allowance: Once you access pension flexibly, your annual allowance drops to £10,000

The Role of Professional Advice

The interaction between pensions, ISAs, income tax, and inheritance tax can be complex. What works for one person may not suit another. Factors such as your total wealth, family situation, health, and goals all play a role.

A qualified financial adviser can help you:

• Model different withdrawal scenarios
• Understand the tax implications of various strategies
• Integrate your pension and ISA planning with wider estate planning
• Adapt your strategy as rules and circumstances change

Summary: Key Takeaways

The question of pension vs ISA for retirement income doesn't have a one-size-fits-all answer. However, some key principles can guide your thinking:

• Tax efficiency matters: Consider your tax band before and after withdrawals
• The 2027 changes are significant: Pension inheritance tax rules are evolving
• Flexibility is valuable: ISA withdrawals offer more flexibility without tax implications
• A blended approach often works best: Using both strategically can optimise your position
• Review regularly: Your optimal strategy may change over time

Whatever your situation, taking time to understand these options can help ensure your retirement savings work as hard as possible for you.

This article is for informational purposes only and does not constitute financial advice. Tax rules can change, and individual circumstances vary. Speak to a qualified financial adviser for guidance tailored to your personal situation.

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