Radical changes to pensions and ISAs have reopened the debate on where is the best place to save for the future including your retirement.
So does a pension’s upfront tax relief trump the tax free growth within an ISA after the pension income has been taxed on the way out?
Crunching the numbers will give you the hard facts on which gives the best net return, but there are a number of other factors which could come into the equation, such as access and Inheritance tax planning as pension can have a more favourable treatment than ISA if your pension benefits have not been accessed.
Where pensions and ISAs differ is on the tax breaks given when payments are made, and when funds are accessed.
Money in
Pensions enjoy tax relief on contributions, for a normal personal pension there will typically be basic rate tax relief added to the pension fund, with any higher or additional relief 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 the 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 numbers ‘crunched’ Assuming investments grow at the same rate for both pension and ISA, what would give the best net return? The table below looks at what could you get back from an investment of £15,000 out of post-tax earnings, left to grow 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.
So, in the majority of cases, the benefit of upfront tax relief with the ability to take a 25% tax-free lump sum will outperform an ISA on a like for like basis. The exception to this is a basic rate taxpayer funding a pension and paying higher or additional rate on the benefits on the way out. This situation could become more common under the new pension freedom if savers try to access their funds in large chunks. This is why advice on taking retirement income is essential.
A big factor in deciding what to do is that an ISA can be accessed at any age. There’s no need to wait until age 55. So an ISA could be preferable if saving towards life events that are likely to occur before this age, or simply as a ‘rainy day’ fund. But that freedom could be an unwelcome temptation for less disciplined retirement savers.
There remains a strong argument for having both pensions and ISAs together. And this may be the case where a large amount is needed for a particular purpose and taking it from the pension could mean that the income becomes taxed at either 40% or 45%. Having some savings and using them for large one-off expenditure could avoid income tax at the higher rates (and the loss of the personal allowance if income exceeds £100,000).
As always, please speak with one of our consultants if you require any financial planning assistance.
