For a long time, there was a simple rule for retirement planning. You would spend your taxable investments first, then your ISAs, and leave your pension until last.
This made sense because pensions were usually not counted for inheritance tax. They were a good way to pass money on to your family.
But things are changing. From April 2027, pensions you do not use will usually count for inheritance tax. Because of this, some people now say you should spend your pension first and keep your ISA for later. That sounds like it makes sense. But it might not be right for you. AJ Bell research shows there is no one right answer. It depends on your tax rate and the tax rate of anyone who might inherit your pension.
Why spending your pension first is not always best
Let’s say you need £40,000 a year from your savings. The £40,000 you get from an ISA is £40,000 you can spend with no income tax payable. If you use your pension, you might need to take out more than £40,000, because some of it will be taxed. Spending your pension now could mean less inheritance tax later. But you might pay more income tax while you are alive.
You need to look at both sides. The real question is not just how to pay less inheritance tax. It is how to get the best result for you and your family.
Here are four examples to show how the answer can change.
Example 1: You pay 40% tax and your beneficiary pays 40%
In the first example, there is a £1 million pension and a £1 million ISA. The person needs £40,000 a year after tax and pays higher-rate tax. Their beneficiary will also pay higher-rate tax. If they spend the pension first, the total tax paid is about £180,000 less after 15 years. You might think this means spending the pension first is best. But it is not that simple.
Even though less tax is paid, the person who inherits the money gets about £24,000 less than if the ISA was spent first.
This is because paying more income tax now means there is less money left to grow over time.
This shows that paying less tax does not always mean your family gets more money.
Example 2: You pay 20% tax and your beneficiary pays 40%
Now let’s change the tax rates. The person pays basic-rate tax, but their beneficiary will pay higher-rate tax. In this case, it is much better to take money from the pension now.
Spending the pension now means about £116,000 less tax is paid, and the person who inherits gets about £108,000 more.
This is because you can take the pension now and pay only 20% tax, instead of leaving it for someone else to pay 40% tax later.
So in this case, it makes sense to take some pension money earlier.
Example 3: You pay 40% tax and your beneficiary pays 20%
If the tax rates are the other way round, the answer changes again. Here, the person has a £1.5 million pension, a £1 million ISA, and needs £50,000 a year after tax. They pay higher-rate tax, but the person who will inherit pays only basic-rate tax.
If you spend the ISA first, the total tax bill is about £9,000 lower. More importantly, the person who inherits gets about £215,000 more. If you take a lot from the pension while paying 40% tax, you end up paying £500,000 in income tax over your lifetime.
If you leave the pension invested, more money can grow, and the person who inherits it might be able to take it out at a lower tax rate.
So even with the inheritance tax changes, it is still better to keep the pension in this case.
Example 4: You pay 45% tax and your beneficiary pays 20%
The difference is even bigger if you pay the highest tax rate. In this example, there is a £2 million pension, a £1 million ISA, and you need £80,000 a year after tax. If you spend the pension, you will pay about £982,000 in income tax over 15 years.
If you take the ISA first then you end up paying more inheritance tax later on, but that doesn’t mean that spending the pension first is the better option. The ISA-first plan means about £56,000 less tax overall and leaves about £459,000 more for the beneficiary. The client avoids paying 45% tax on large pension withdrawals and leaves more money to someone likely to pay only 20% tax.
The gap is big.
There is no one size fits all withdrawal order
The new rules on inheritance tax have made retirement planning more complicated. That doesn’t mean that people should use up their pension first. The right strategy depends on factors such as:
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Your current income tax rate.
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Your expected future tax rate.
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This includes your other income, such as the State Pension.
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The amount that you have to spend.
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The amount in your ISA and your pension.
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Whether or not inheritance tax will apply to your estate.
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Who is going to inherit the pension?
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Their most probable position regarding income tax.
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The duration for which the money might stay invested.
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Whether you intend to spend the money yourself or make gifts during your lifetime.
The AJ Bell examples use 5% investment growth each year, a 15-year time frame, and assume inheritance tax applies. These are just examples, not predictions. Real life is messier.
It is easy to forget what matters most. Your retirement money is there to pay for your life first. Saving your children inheritance tax is not always worth it if you end up paying much more income tax yourself. Keeping all your ISAs just because they are tax-free may not make sense if you can take pension money now at a low tax rate.
For most people, it makes sense to use a mix of accounts. You do not have to spend one and then move to the next. You might take just enough pension income to use your tax-free allowances and lower tax bands, then use your ISA for extra spending. Later, when you get your State Pension or other income, you might need to change the balance again.
Your plan for taking money out can change as you go through retirement. That is normal.
The important question has changed
From April 2027, leaving your pension untouched just because it was outside your estate will not be as simple as before. But there is still no simple answer about whether you should always spend the pension first.
The question is not which is better, pensions or ISAs. The real question is how your pension, ISA, tax, spending, and estate all fit together for the rest of your life. That takes planning.
