Pension or ISA..?

melancholly

cheerfulcat wrote:

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.

Can I ask for a bit more advice on this?! (and in simple language for the pensions simpleton that I am!!). I'm studying for a phd so get a stipend that is tax free. I have an ISA but am not going to manage to put in more than £2000 a year. I'm starting to think about pension things (not least because my parents were caught out in the equitable life fiasco and are nagging me to plan for the future)! Is it worth starting a private pension with the small amounts a month I will have/will this benefit me more than an ISA? I am thinking of trying to see an IFA but I want to know enough to be able to ask the right questions.... I will only have 2 more years before I (hopefully) get a proper income and start paying tax again. I am also keeping up with voluntary NI contributions for the time that I'm studying so that I don't lose out on the state pension.

ReportInvestor

I don't agree with cc's reasoning here. You would get the tax relief if and when you transfer any ISA savings into a pension at a later date when you are working.

cheerfulcat

Hi, melancholly

Contributions to a pension fund are tax free, within certain limits. The way it works is that for every £1 you want to put in, you *actually* put in 78p ( basic rate taxpayer ); the taxman puts in the 22p of tax that you paid. But everyone can contribute up to £2808 per year and the taxman will still pay in 22p per 78p, regardless of whether or not they paid tax.

Whether a pension will benefit you more than an ISA is another question. The pros and cons have been discussed quite a bit, both here and on theMotley Fool. FWIW, my own strategy is to contribute to both.


Edit:

I don't agree with cc's reasoning here. You would get the tax relief if and when you transfer any ISA savings into a pension at a later date when you are working.

Reportinvestor, my reasoning is that a non-taxpayer is getting an extra contribution from the taxman. Am I wrong ? Happy to be corrected!

Paul_Herring

cheerfulcat wrote:

I don't agree with cc's reasoning here. You would get the tax relief if and when you transfer any ISA savings into a pension at a later date when you are working.

Reportinvestor, my reasoning is that a non-taxpayer is getting an extra contribution from the taxman. Am I wrong ? Happy to be corrected!

As I understand it...

[Assuming no more substantial changes in the tax law that applies..] that extra contribution would be made whenever that money enters the pension wrapper, be it 'now' when the person isn't earning or some years hence when the person concerned is earning. For every £78 net that the person puts in, HMG will add £22 to it. The only limits that apply 'now' is that there is an upper limit as to how much can be put in at the moment (the £2808 net, £3600 gross.) Once earning, the gross limit rises to 100% of gross pay.

In that respect, and assuming the same underlying investment was used, there is little difference between putting it into a pension now, or an ISA now, then a pension later.

Except that when it goes into the pension it has to stay there until retirement.

I await correction from DH/others....

ReportInvestor

PH puts it pretty well, and dh has already accepted the Maths behind it.

I shall say this only once

IIRC you get 22% tax relief once and it doesn't matter when you get it.

Even if Melancholly never did a stroke of work in his life & his ISAs soared, he could still get 22% tax relief on several annual £2,800 pension investments in future years.

I would accept that there may be a slight issue of possible initial charges x2 if you take the ISA first route.

EdInvestor

THe "tax relief" is of course only tax deferred - as you pay tax on the income when you get it as a pension after retirement (apart from the 25% tax free cash.)

So unless Melancholly plans to be a non taxpayer in retirement as well as now, which doesn't seem likely since she is studying for a PhD, then she's probably better advised to just keep on with the ISA, unless she's quite happy with having her capital tied up in the pension forever and an income available only after 55.

A pension is quite a good thing to have if you're a higher rate taxpayer, as you get the 25% tax free cash lump sum on retirement, PLUS - and this is the really big incentive - an 18% tax refund as well , cash in hand back every year to spend.:)

For other more lowly beings, the ISA's a better deal.

michaels

Sorry to chuck something else into the mix

If you have a pension and buy an annuity the 'rate' you recive is higher than real interest rate as in effect you are 'living of the capital' as well as the income. I understand that all this income will be taxable.

If you leave the money in an isa, you will pay tax on income from interest (although if it is all in the isa then this will be tax free too) but not on any 'income' from spending the capital - does this make sense?

Paul_Herring

michaels wrote:

Sorry to chuck something else into the mix

If you have a pension and buy an annuity the 'rate' you recive is higher than real interest rate as in effect you are 'living of the capital' as well as the income. I understand that all this income will be taxable.

Not necessarily. For starters, you only have to buy an annuity with 75% of the pension - you have the option of taking the other 25% tax free.

Of that annuity, the first (2005/6) £( Income Tax Allowance - Basic State Pension.) is tax free.

If you leave the money in an isa, you will pay tax on income from interest (although if it is all in the isa then this will be tax free too) but not on any 'income' from spending the capital - does this make sense?

But you don't get 25% of 22% of the value of that ISA back from the government because it didn't go into a pension wrapper.

I'm sure there's a break-even point here, along with lots of other assumptions.

Like will ISA's or their equivilent even exist when I'm 95 - the new government retirement age by the time I get there

cheerfulcat

EdInvestor wrote:

THe "tax relief" is of course only tax deferred - as you pay tax on the income when you get it as a pension after retirement (apart from the 25% tax free cash.)

So unless Melancholly plans to be a non taxpayer in retirement as well as now, which doesn't seem likely since she is studying for a PhD, then she's probably better advised to just keep on with the ISA, unless she's quite happy with having her capital tied up in the pension forever and an income available only after 55.

A pension is quite a good thing to have if you're a higher rate taxpayer, as you get the 25% tax free cash lump sum on retirement, PLUS - and this is the really big incentive - an 18% tax refund as well , cash in hand back every year to spend.:)

For other more lowly beings, the ISA's a better deal.

25% tax free could be a pretty tidy sum if someone has invested regularly and wisely over 40 years! And btw higher rate taxpayers are not particularly thin on the ground so perhaps those who dislike pensions should point out more frequently that if you pay HRT *or are on the brink of the HRT band* contributions to a pension fund can make a lot of sense, as they are added to the BRT band.

EdInvestor

michaels wrote:

f you leave the money in an isa, you will pay tax on income from interest (although if it is all in the isa then this will be tax free too) but not on any 'income' from spending the capital - does this make sense?

To clarify,

When you withdraw either capital or income from an ISA it is tax free.

Only 25% of a pension fund can be withdrawn, and this is tax free.

The rest must be used to provide a taxable income. This can either be done by buying an annuity, where you give the capital to an insurance company and it provides you with a guaranteed income for life ( returning about 3-7%on your capital depending on age, gender, whther index linked with spouse's pension, etc, .)

Or it can be done via a system called "income dradown" where you leave the money invested and take an income from the earnings. This pays out a higher income, though not much higher, and it is still taxed.Your income can grow using this system but there is a risk also that it could fall.

With the annuity system you lose your capital immediately.With the drawdown, if you die before 75 you can leave the money in cash to your dependants minus a 35% tax charge.

At 75 you currently must buy an annuity but the rules will change in April - thought what to exactly, isn't yet clear.