Pension or ISA ?
It is folly for a man to pray to the gods for that which he has the power to obtain by himself – Epicurus
Accepted logic is, for savings where access is required before age 55 ISA’s are a great option, but with pension freedom upon us and unlimited access pensions after age 55 they are probably the best option for longer term saving goals (not just pension income). The advantages of pensions are well known, in essence pensions enjoy:
- tax relief on contributions (increasing the initial investment and helping to manage tax traps such as Child Benefit tax charge etc.)
- tax efficient growth
- on withdrawal, part of the funds are paid tax free with the balance taxable as income
- ability to pass on wealth on death, tax-free before age 75, taxable in the hand of the recipient after age 75 (usually without Inheritance tax).
A very compelling list of advantages, so it would seem unwise not to take full advantage of pensions. In basic terms when using a pension for savings, a target amount will cost less or saving a set amount will produce more.
Sounds good, but the words are not exactly motivating – so let’s look at some numbers:
Paul is 45, a higher rate tax payer and wants to save a net £200 per month for 10 years. If we assume a 4% per annum gross return, the returns from the main savings options, ignoring product costs, are as follows:
Interest credited 2.4% net
Interest credited 4% gross
Interest credited 4% gross
Ok, so the pension gives a much higher fund, but isn’t there tax to be paid when Paul withdraws his money? The answer is yes, 25% of the fund will be tax-free with the balance being taxed at marginal rate.
So assuming Paul is still a higher rate tax payer his total income does not breach the £100,000 personal allowance trap and he chooses to withdraw all funds at once; he will receive £12,265 tax free and £22,076 after applying 40% tax on the balance, a total of £34,341. A substantial £7,229 increase on the bank account and £4,906 on the ISA; for doing nothing other than selecting the right savings wrapper.
There are however some limitations which need to be considered. If pensions are the best post 55 savings wrapper why would you use anything else?
If any of these apply, alternative investments (such as ISA’s) should be considered for at least some of the clients savings.
The maximum which can be accumulated in a pension, without incurring tax penalties, is currently £1.25m (this figure has been reducing over recent years and in his recent Budget the Chancellor announced a further reduction to £1m with effect from April 2016 – although protection has always been offered if savers were already above the revised figure at the point of reduction). So, savings need to be managed to stay within this over-riding limit.
The maximum that can be invested annually into pension without tax penalty is normally £40,000, called the Annual Allowance (although there is potential to “mop-up” up to 3 previous years unused allowance).
If pensions are accessed using the new flexibility rules, this will reduce future contributions to £10,000 per annum (Money Purchase Annual Allowance). To gain tax relief on the contributions, they are limited to the higher of £3600 (gross) or 100% of relevant earnings.
If there is a requirement to save more than these limits, alternative savings methods need considered for the excess.
All legislation is obviously subject to change. Some individuals may be put off pensions as they are “always changing”. It should be remembered that in the past whenever detriment has occurred, there has always been rules’ protecting affected individuals. Detrimental changes usually apply to those with larger contributions and bigger funds, for people paying less than £10,000 with no lifetime allowance issues most changes in the last 15 years have actually been positive.
Rate of tax at withdrawal
Where exit tax is higher then entry tax relief, ISAs return more than pensions for the same net outlay.
Although statistics indicate that the vast majority of people pay a lower rate of tax when they access their pension savings, there are a small number of people who are liable to a higher rate. If the case, this would impact on the tax efficiency of pension savings, although a planned withdrawal strategy could minimise this.
Need for access to savings Pre age 55
If access to some savings is required before age 55, these may be better placed within an ISA – a pension would not normally be accessible pre 55. The funds set aside for emergencies would certainly fall into this category. Many say locking their savings away is an advantage, as it instills a bit of discipline, but it still needs consideration.
From time to time, there may be the need for extra cash for unforeseen circumstances. If increased cash amounts are required it may be wise to have a source of tax free/tax deferred income to draw on so as not to expose the pension funds to unnecessary taxation on withdrawals.
If it is possible to work within the above limitations, it’s folly not to consider pensions as the primary method for long term savings, given the additional support being provided.
Individuals won’t have to pray for a good retirement if they just make sure they pay their money into the right savings vehicle.
Source: Les Cameron – Prudential