Pension or ISA..?

ReportInvestor

Apologies to dh.

My turn to have egg on my face as dh is quite right here . He had learned the earlier lesson and applied it correctly.

If you save in an ISA and then switch it to a pension (assuming the same growth in both and the same tax relief) then you have got the same size pension fund as if you had saved into a pension from the start.

By the same token, if you are saving for retirement and have a choice of a pension or an ISA, you do not build up a bigger % difference in your savings pot with a pension if you start saving sooner. This had been dh's mistake in a much earlier thread (which cc is starting to repeat above).

I'll edit my previous post in order to avoid spreading confusion.

What the figures show is that the important thing, to take advantage of compounding, is WHEN you start saving, not the decision over the pension / ISA wrapper

On a separate note, what else is worth considering as variables on the ISA v Pension idea?

If someone is going to become a higher rate taxpayer at a later date it makes the ISA first / pension later route more attractive.

If someone is already a higher rate taxpayer then there is the risk that higher rate tax relief on pensions may be eroded by government at a later date. But that is more speculative.

EdInvestor

cheerfulcat wrote:

I can't help thinking that logically, all other things being equal, the compounding effect over the years of the tax relief up front *has* to make a difference.

Nope. It doesn't.

Some mathematical workings on it here

dunstonh

Apologies to dh.

My turn to have egg on my face as dh is quite right here . He had learned the earlier lesson and applied it correctly.

Thank goodness for that. I had allocated a couple of hours today to get to the bottom of this one way or another.

Funny thing is that if you google "pension tax relief compounding" you do get responses which say compounding does have an effect. I know from others that there is an assumption that tax relief gets compound growth above that of other savings. I wonder if this is an old wives tale based on old information, a bit like the every 5 years you need to double your contribution if you leave it. Once it was correct. However, it is no longer the case.

On a separate note, what else is worth considering as variables on the ISA v Pension idea?

1 - Pensions contributions can increase your working/childrens tax credits. ISAs cannot.
2 - Pensions can have lower charges on funds than ISAs
3 - Tax relief today may be higher than what is available in the future (and vice versa)
4 - Tax relief could be pulled in the future.
5 - Your income may not be enough in the future to allow a larger contribution into a pension with tax relief. i.e. you may need a number of years which would need you to remember.
6 - The accessibility of ISAs can be a benefit but it can also be a negative point for people who require the money to be tied up to prevent them from dipping into it and leaving them nothing in retirement.
7 - death benefits on pensions would be higher than ISA. On death, the fund value of each is paid out. Because of tax relief, the pension fund value would be higher.
8 - Pension could reduce IHT liability as the fund does not form part of the estate. The ISA would.

whiteflag_3

Sorry Ed, I thought going back to the original poster and dh we were talking about the size of the pension/isa lump sum pot, not the benefits of tax free cash, final pension etc which is what your link refers to.

Im with cheerfulcat in that the compoumding effect on the bigger amount in the early years must make a difference, although like DH not totally confident. Hopefully i will get time in the next day or two to prove myself wrong!

ReportInvestor

whiteflag wrote:

Im with cheerfulcat in that the compoumding effect on the bigger amount in the early years must make a difference

That is wrong. Test it on a spreadsheet like this.

Put in 7% growth on £78 invested pa over five years v 7% growth on £100 pa over five years. There is still 22% difference between the original investment and the final total. That disappears when you transfer it into a pension getting 22% basic tax relief.

dunstonh wrote:

If you put £50pm into an ISA for the same timescale and then at the end placed it in the pension as a lump sum, the amount of tax relief would be exactly the same.

This is dh's statement with which I am agreeing.

AND the investment growth on the total amount invested is also the same, all other things (growth rate, charges, tax regime etc.) being equal.

cheerfulcat

ReportInvestor wrote:

This had been dh's mistake in a much earlier thread (which cc is starting to repeat above).

I'll edit my previous post in order to avoid spreading confusion.

What the figures show is that the important thing, to take advantage of compounding, is WHEN you start saving, not the decision over the pension / ISA wrapper

I make my own mistakes, thank you

You are quite correct, the calculations seem to show that there is no difference between getting the tax relief now and getting it later. Thanks for the link, Ed, Gengulphus is as lucid as ever.

On a separate note, what else is worth considering as variables on the ISA v Pension idea?

If someone is going to become a higher rate taxpayer at a later date it makes the ISA first / pension later route more attractive.

If someone is already a higher rate taxpayer then there is the risk that higher rate tax relief on pensions may be eroded by government at a later date. But that is more speculative.

Not so speculative - the Turner report had a throwaway line to the effect that the higher rate tax relief was unfair to lower earners - the clear implication was that it should be abolished.

Edit: just to add to dh's excellent list, there is a distinct advantage to the *non*-tax payer in contributing to a pension as opposed to an ISA since the tax relief still applies.

whiteflag_3

£780 p.a into ISA for 20 years @ 7% = £34214.84

£780 p.a. net into pension means you get £1000 going in p.a. because of tax relief. Therefore:
£1000 p.a. gross into Pension for 20 years @ 7% = £43865.17

So, pension looks higher. However, take that ISA final figure and add 22% tax relief and you get the same as the pension.

dunstonh i have done the calculation (manually) and get exactly the same as you .However £34241.84 +22% = £41775.04 which is £2090.13 less

ReportInvestor

Is that because you are multiplying 34241 by 1.22?

You would need to multiply it by 1.28 to get the basic rate tax relief.

michaels

whiteflag wrote:

dunstonh i have done the calculation (manually) and get exactly the same as you .However £34241.84 +22% = £41775.04 which is £2090.13 less

I think the calc should be 43865.17-22% = 34,241

However I think the pension investment will be worth more as interest will be payable on a larger amount in each period, thus when you get to the point where tax is being paid there will be a larger pot providing a larger income. This is very much an all things being equal arguement - ie ISAs will continue and pension rules will not change.
I think the whole basis of this discussion is floored however as pension money has to mostly but an annuity.

whiteflag_3

ill get me coat!

i may be able to work out twenty years compounding yet cant do percentages doh!