Pension v ISA

We’ve put the ‘all new’ 2015 pension and the recently modified NISA, head to head to see which will come out top in our 0 – £60k performance shoot-out and which one is the best-in-class family friendly model.

Pensions and ISA compared
According to HMRC 45% of savers in stocks and shares ISAs are aged 55 or over. So there are no access concerns for a large number of savers.

These savers already understand the mantra of ‘gross is good’. Choosing an investment on which there’s no additional tax due on investment growth and income. And the exact same tax treatment is available on funds held within a pension.

ISA savings can be dipped into at any time; there’s no need to wait until reaching age 55.  So an ISA has its place if saving towards life events that are likely to occur before this age, or simply as a ‘rainy day’ fund. However that freedom could be an unwelcome temptation for less disciplined retirement savers.

But what about those savers who don’t need access or are close to or over 55? Which of these investments will give them the most spendable income or provide the greatest inheritance for their families?

One area where pensions and ISAs differ is on the tax breaks given to individuals when payments are made, and when funds are accessed.

Money in

  • Pensions enjoy tax relief on contributions. For defined contribution schemes, savers will normally pay in an amount net of basic rate tax, with the provider adding basic rate tax to the fund. Any higher or additional relief is claimed through self-assessment. So a £10,000 pension contribution will require a payment of £8,000. A higher rate tax payer would be able to claim a further £2,000 tax relief via their tax return and this will reduce the tax they pay on their other income. So the net cost to an investor paying higher rate tax is £6,000.
  • There’s no tax relief for payments into an ISA.

Money Out

  • Up to 25% of the pension fund can be taken completely tax free. The balance is taxed at the saver’s highest marginal rate of income tax.
  • All withdrawals from an ISA remain tax free.

The 0 – 60 performance shootout
Assuming investments grow at the same rate for both pension and ISA, what would give the best net return?

  • Husband and wife both invest £15,000 into an ISA.
  • For the same net cost they could invest £18,750 into their pension as a basic rate taxpayer or £25,000 as a higher rate taxpayer.

With the same 4% return after charges on both the ISA and pension; how long would it take for their combined investment to grow to £60,000?

Of course, it’s not just a case of looking for the first past the post but which one gives the best return after tax has been deducted. The table below shows the position for some of the most common scenarios of tax rates on the way in and way out.

Fund hits £60K £60K in the pocket after tax
ISA 17.5 years 17.5 years
Pension  (20%/20%) 12 years 16 years
Pension  (40%/40%) 5 years 14 years
Pension  (40%/20%) 5 years 9 years

For a more complete performance picture the table below looks at what could you get back from an investment of £15,000 out of post-tax earnings, this time left to grow at 2.5% pa over an investment period of 10 years. It covers each of the conceivable combinations of tax rates on the way in and the way out.

% tax rate in/out Pension return ISA return Pension gain ISA gain
45/45 £23,129 £19,201 £3,928
45/40 £24,438 £19,201 £5,237
45/20 £29,675 £19,201 £10,474
40/45 £21,201 £19,201 £2,000
40/40 £22,401 £19,201 £3,200
40/20 £27,202 £19,201 £8,001
20/45 £15,901 £19,201 £3,300
20/40 £16,801 £19,201 £2,400
20/20 £20,401 £19,201 £1,200

Assumptions:

  • Returns are based on a real rate of return of 2.5%.
  • Investments chosen under each plan are the same.
  • Neither pension payments in, nor withdrawals made, have any impact on the personal allowance.
  • Payments into the pension are made within the annual allowance.
  • Payments out of the pension don’t attract a lifetime allowance charge.
  • Tax rates and allowances are at current levels.

The family friendly option
For some individuals it may be just as important to also consider what can be passed on to family members on death.

The new ISA inheritability rules provide a surviving spouse or civil partner with an increased ISA allowance equal to the value deceased’s ISA at the time of their death. This allows the survivor to benefit from continued tax free investment returns on their spouse’s investments. But it doesn’t keep the ISA out of the spouse’s IHT net. The fund could still suffer a 40% IHT charge on the second death if total assets exceed the IHT nil rate band.

Pensions on the other hand are typically free of IHT. And there are new rules on how pension wealth can be inherited. Restrictions have been lifted on who can inherit a drawdown pension. From April it will be possible to nominate anyone to receive a pension pot and for them to carry on taking an income from it. This applies even if they are below the normal pension age of 55, allowing children or grandchildren to have immediate access.

By keeping the money within the pension wrapper, they benefit from the same tax free investment returns as an inherited ISA. But unlike the ISA, it isn’t limited to spouses and civil partners but can apply to anyone the deceased wants to benefit from their pension. And it also means the funds don’t make their way into the beneficiary’s estate for IHT.

In addition the rates of tax on inherited drawdown funds have fallen too. It no longer matters whether funds are crystallised or uncrystallised. The same rates will apply to both.

  • Should the scheme member die before age 75, any income drawdown by the beneficiaries will be tax free.
  • For deaths after age 75 income will be taxed at the beneficiary’s marginal income tax rate.

These rates will apply regardless of whether the fund is taken as an income or a lump sum. Although for the 2015/16 tax year only, taking the whole fund as a lump sum on death post 75 will be taxed at 45% before reverting to the beneficiary’s marginal rate in April 2016.

ISA Pension
Death pre 75 No income tax or CGT.
Forms part of the estate on death.

  • Spousal IHT exemption available for spouse or civil partner.
  • Potential 40% IHT for all other beneficiaries.
Lump sums tax free.
Outside estate for IHT.No tax payable by beneficiary on income withdrawals.
Outside estate for IHT.
Death post 75 No income tax or CGT.
Forms part of the estate on death.

  • Spousal IHT exemption available for spouse or civil partner.
  • Potential 40% IHT for all other beneficiaries.
Lump sum taxable at beneficiaries marginal income tax rate.
Outside estate for IHT.Income withdrawals taxable at beneficiaries marginal income tax rate*.
Outside estate for IHT.*45% for lump sums in 2015/16 only


Part-ex your ISA
The pension proves to have the better performance in most scenarios and greater flexibility on passing on wealth to family members. So with the April’s pension freedoms taking access out of the equation for the over 55’s, it begs the question….should individuals trade in their existing ISA savings for a pension contribution?

Of course, this requires sufficient earnings, annual allowance and lifetime allowance headroom. It’s certainly something worth considering over the years leading up to retirement. And carry forward and spreading contributions across tax years can help. The result could be an increased fund with more tax efficient wealth transfer options.

Conclusion
It’s a fact that pensions will, like for like, outperform ISAs in the majority of client scenarios. This is down to the combination of tax relief on contributions and the ability to take a quarter of the fund tax free.

As a result there are very few situations where the ISA will have the upper hand. The only common scenarios would be where:

  • Access is need prior to age 55, and
  • Anyone receiving tax relief at 20% on contributions but by accessing their pension in one go end up paying tax at 40% on a large slice of their pension fund.

Anyone who has sufficient allowances and will receive tax relief at 40% on pension contributions will always be in a better in position saving in a pension regardless of how much tax they pay on the way out.

Factor in the new pension death benefit rules and the case for pension becomes even stronger. It may require a shift in mindset, but crunching the numbers suggests that a pension ought to be the default saving choice and moving existing savings into pensions in the run up to retirement should always be considered.

 

Source:  Standard Life