Hardly a year goes by without some significant change to the pensions legislation. The one area that the government hasn’t touched is the upfront tax relief on the contributions, but there is widespread speculation that this could be reduced to a flat rate or removed altogether with the details due to be announced in next year’s Budget.

In view of the high degree of uncertainty you might want to put some of your retirement savings into an ISA. These are the most flexible form of tax shelter and have not been subjected to anywhere near the same level of upheaval as they are less expensive for the government in terms of the lost tax revenue.

Stocks & Shares ISAs operate like a normal broking account other than the fact that the income and capital gains are all tax-free. You can use them to buy and sell a wide range of permitted investments including UK and overseas shares, funds and bonds, although some providers offer a more limited choice than others.

The accumulation stage

For the tax year ending on 5 April 2016 you can pay in a maximum of £15,240 into a Stocks & Shares ISA. This can either go into an existing account from an earlier tax year or a new one with a different provider.

Rebecca O’Keeffe, head of investment at Interactive Investor, says that £15,000 invested every year and generating a net growth rate of 5% would be worth £198,102 after 10 years, £520,789 after 20 years and £1,046,412 after 30 years.

‘These numbers are all highly attractive and show that you could build up a considerable ISA fund which could provide a very attractive retirement income, free from further income tax.’

There is no upfront tax relief on the contributions as there is with a pension, but once the money has been invested the savings within the account are the same. One of the main benefits is that all the gains are free of Capital Gains Tax (CGT), otherwise amounts in excess of your annual allowance of £11,100 would be taxed at either 18% or 28%.

Even if you don’t expect to go over this limit in the current tax year it is still worth sheltering your assets, especially if you contribute to an ISA on a regular basis, as there is every chance that you could build up a substantial portfolio.

Danny Cox from Hargreaves Lansdown says that ISA savings have become more attractive due to their tax-free nature and the increase in the subscription size. ‘The limiting of pension tax relief and the reduction in the lifetime allowance make an ISA an obvious second choice for retirement saving.’

Reduce tax on income

Higher and additional rate taxpayers who use their ISA to invest in individual company shares or equity funds will not have to pay any further tax on the dividends. This is especially valuable for those who receive dividend income in excess of the new tax-free dividend allowance of £5,000, as the effective tax rate is due to increase when it comes into force on 6 April 2016.

Charles Galbraith, managing director of AJ Bell Youinvest, says that once the £5,000 allowance is exhausted the tax due on dividend payments will be higher than before if you are a higher or additional rate taxpayer.

‘Investors should look to make the most of their allowances when it comes to their dealing and savings accounts and then use an ISA to manage tax liabilities on the next portion of their portfolio.’

The other main benefit is that interest on bonds and bond funds held in an ISA is free of income tax, which represents a big saving for both basic and higher rate taxpayers. From 6 April 2016 the first £1,000 of this income for a basic rate taxpayer will be covered by the new personal savings allowance, although most people will probably use it to cover the interest on their deposit accounts. For higher rate taxpayers the allowance will be just £500.

‘The beauty of holding assets in an ISA is that investors don’t have to worry about tax and utilising allowances as their investment builds up tax-free and can be withdrawn whenever they need it with no tax liability,’ notes Galbraith.

Early retirement

You are not normally allowed to take money out of a personal pension until you are 55 and workplace pension benefits may not be accessible until you are 60 or older. Once you get to that stage you can usually withdraw up to 25% of the accumulated capital as a tax-free lump sum with the remainder taxed as income as and when you draw it.

There are no such restrictions with ISAs as the money can be withdrawn tax-free whenever you want regardless of how old you are. The one point to bear in mind is that if you want to put it back later it will count towards your annual ISA allowance.

Those who save enough money can use an ISA to retire early as they can draw a tax-free income or take out the capital before they can access the cash built up in their pension.

‘Most people start to draw at least one of their pensions when they retire, although retirement is usually phased in with part-time work rather than a cliff edge process. Some live off the capital in their ISAs before their full pensions kick in, although most people like to spend income not capital,’ explains Cox.

A retiree with sufficient savings could limit their pension withdrawals to their personal allowance so that there would be no tax to pay on the income. They could then take out whatever else they need tax-free from their ISA. This would enable them to enjoy a potentially sizeable tax-free income in retirement, especially if they also make use of the new personal savings allowance and tax-free dividend allowance.

A winning combination

Someone aiming to achieve a £30,000 annual retirement income could rely on the State Pension to provide about £7,000. If they saved £200,000 in an ISA and generated a 5% yield this would provide a further income of £10,000 and they would then need an additional £225,000 in a pension to deliver the remaining £13,000, although this would be at a flat rate and its value would diminish over time due to inflation.

‘The ideal combination of retirement savings incorporates the State Pension, other pension savings and ISA income, which allows you to avail yourself of your full personal allowance and minimise your taxable income,’ explains O’Keeffe.

Until recently all the tax benefits of an ISA were lost when you die, but where account holders pass away on or after 3 December 2014 their surviving spouse or civil partner will inherit their ISA benefits. This takes the form of an additional ISA allowance equal to the value of the accounts on death.

‘The new rules that allow an ISA to be effectively passed on to a surviving spouse or civil partner have made ISAs even more valuable, but in a straight comparison of pensions and ISAs the most beneficial way to save for your retirement remains a pension,’ says O’Keeffe.

As long as pensions continue to offer upfront tax relief they will remain the most attractive way of saving for retirement, but ISAs provide a useful complimentary tax shelter and they will become even more valuable if the government scales back the pension benefits in the 2016 Budget.