A 66-year-old retiree is evaluating the most tax-efficient method to manage their finances after recently applying for the state pension. Living in a mortgage-free home and renting out another property with a mortgage, they possess a total of about £100,000 in various pension pots and an equivalent amount in ISAs. The individual seeks guidance on whether to withdraw a 25% tax-free lump sum from their pension pots and invest it in ISAs or to leave the pensions untouched while using their ISAs for income.

Defined contribution (DC) pension plans provide a flexible option for retirement savings, allowing access to funds starting at age 55, which will increase to 57 in 2028. With DC pensions, individuals can withdraw up to 25% tax-free, while any additional withdrawals are subject to income tax. In contrast, defined benefit pensions, or final salary schemes, guarantee a specific income based on salary, rather than offering a lump sum.

Contributions made to pensions receive tax relief based on individual income tax rates. For instance, contributing £80 to a pension automatically gets a £20 boost, and the funds can grow tax-free while invested. The annual limit for tax-relieved contributions to a defined contribution pension is currently set at £60,000, inclusive of contributions from employers. It’s important to note that contributions cannot exceed earned income.

ISAs, while lacking the upfront tax relief of pensions, provide tax-free investment growth and are notably more flexible. Withdrawals from ISAs are completely tax-free whenever needed, and individuals can contribute up to £20,000 annually into these accounts.

In response to the query, there appears to be no significant tax advantage in immediately withdrawing tax-free pension cash and placing it into an ISA. The accessibility of this portion of a pension mirrors that of an ISA. Moreover, many investment platforms offer comparable investment options across both accounts. If certain pensions do not align with this flexibility, it might be worth consolidating them under a single, cost-effective provider, ensuring that exit fees or loss of benefits are considered beforehand.

Interest has surged in the withdrawal of tax-free cash in light of an upcoming budget announcement scheduled for October 30. Some individuals fear potential reductions or eliminations of entitlements. It is generally advisable to base decisions on current tax regulations rather than reacting to speculation.

Furthermore, opting to withdraw tax-free pension cash for investment in an ISA may entail negative inheritance tax (IHT) implications. Typically, pensions are excluded from estate assessments for IHT, and beneficiaries can access the funds tax-free if the account holder passes away before age 75. In contrast, ISA funds are included in the estate for IHT calculations.

This aspect primarily concerns those who exhaust their IHT allowances. For the 2024-25 tax year, the primary tax-free IHT threshold is £325,000 per person, with an additional £175,000 for bequeathing a primary residence to direct descendants, including children and grandchildren. However, passing a main residence to a spouse or civil partner incurs no IHT charges.

If IHT factors into financial planning, pensions often prove to be strategically accessed last in retirement due to their advantageous tax treatment.

Tom Selby, director of public policy at AJ Bell, advocates for improvements in retirement systems, including measures to ban unsolicited pension-related calls and increase pension contribution allowances.