Pension contributions rather than ISA?

savingforoz

Just wondered if you fine people could clarify something for me. I realise that ISAs have the advantage of accessibility over pension funds, but for me that's not an issue as (excepting any unforeseen disasters) I don't intend to raid any funds that I build up in an ISA, as I'm now saving long term for retirement. Given that's the case, am I right in thinking that pension plans are preferable to ISAs due to the government adding in the tax element, so boosting any contribututions that I make?

I realise that I can build up funds in an ISA then transfer those later on to a pension, but I can't see the virtue in that for me. My understanding is that from A day you can only transfer an amount equal to your annual salary each year, and as my salary is peanuts (I take a low salary and the balance of my income is a monthly dividend on a non voting share that I hold in my employer) I'd have to dribble the money in over several years.

All help gratefully received!

EdInvestor

The tax position is like this:

With an ISA you save out of after-tax money, but the fund grows tax free inside the wrapper and both the capital and the income can be withdrawn tax free at any time.

With a pension, the Government tops up the contribution at your highest level of tax going in, and the fund grows tax free. But you can never withdraw the capital at all, apart from a 25% tax free cash lump sum, which can be taken from the age of 55. The income which you can withdraw after 55 is strictly limited and is taxed at your highest level.Ao the Government takes 75% of the tax relief back. (There is no investment gain from the tax relief).

Pension contributions can be paid in at a max of your annual salary capped at 215k.

There are obvious advantages for higher rate taxpayers in pensions as they get 18% of their tax relief refunded in cash. Those who can take advantage of free money from their company may also consider a pension.

Others might regard the rules as far too restrictive and the tax perk far too small to justify them, compared with those applying to the ISA.

dunstonh

In your case, pension contributions could well be better than an ISA due to the fact you do have a lower "real" income which limits your contributions.

Whilst there are merits in the ISA vs pension debate that favour ISAs, one thing is clear that at age 60 or higher, the income from a pension, even with tax deducted is higher than an ISA. If you are looking to provide that income in retirement and capital is not a concern with this contribution, then the pension will provide the higher income.

savingforoz

Thanks - could you just clarify one thing - so I'd end up with a larger retirement fund if I save via a pension rather than an ISA, due to the tax bonus being added? So say £300pm would achieve a larger fund than an ISA, assuming they were both invested the same, due to the tax relief?

(In reality, I intend to use both pensions and ISAs, due to being capped on the pension contributions becuase of my low (£9,000) annual salary, but just wanted to know which way to bias the split between pensions/ISAs).

Thanks guys

dunstonh

Thanks - could you just clarify one thing - so I'd end up with a larger retirement fund if I save via a pension rather than an ISA, due to the tax bonus being added? So say £300pm would achieve a larger fund than an ISA, assuming they were both invested the same, due to the tax relief?

Correct. With the same investment funds available on pensions and ISAs, the only difference really after that point is charges and taxation. Both have tax free growth but the pension contribtuions get enhanced by the tax relief. This would give you a 22% higher fund value. Then you have charges and with pensions nowadays, these can be lower than ISAs although the difference is not enough to get concerned about.

(In reality, I intend to use both pensions and ISAs, due to being capped on the pension contributions becuase of my low (£9,000) annual salary, but just wanted to know which way to bias the split between pensions/ISAs).

In my opinion, that is the best way. Aim to use up your personal allowances (and lower rate band) in retirement with the pension income with any surplus coming from the ISA.

savingforoz

Thank you dunstonh, that's clarified things for me. Just to say I have decided to get much more proactive and hands on with managing my financial affairs, and have found your posts, whether replying to me or to other people, very helpful.

EdInvestor

Thanks - could you just clarify one thing - so I'd end up with a larger retirement fund if I save via a pension rather than an ISA, due to the tax bonus being added? So say £300pm would achieve a larger fund than an ISA, assuming they were both invested the same, due to the tax relief

Yes of course.But then you pay tax on the income when it's paid out to you, so it ends up the same. [Excluding the tax free cash which is an extra.] But as I said before,the restrictions are such that the extra hardly compensates.

In particular the loss of access to your savings forever and the strict limits on how much you can take out of the fund are extremely irksome.

Things have improved a bit - after 5 solid years of campaigning, at least now buying an annuity is not compulsory.

savingforoz

Thanks, Ed, that's helpful too. As I intend to live a very, very long life indeed after retirement, being seriously into healthy living, then the fact the income is taxed is also something to consider for me. I definitely intend to get into share based ISAs ASAP - it's just a question of how to balance extra pension contributions with extra ISA contributions. So thanks to both Ed and DH.

dunstonh

If the annuity rate is 6.5% and taxed, that makes it 5.07% net(assuming all at 22%). With an ISA you should work on 5% as a target income.

So, with a pension you get 5.07% after tax and an ISA 5.0% with no tax to pay. Plus the pension fund would be 22% higher. Even with annuity rate fluctuations, there is still an awful lot of scope.

EdInvestor

dunstonh wrote:

So, with a pension you get 5.07% after tax and an ISA 5.0% with no tax to pay. Plus the pension fund would be 22% higher. Even with annuity rate fluctuations, there is still an awful lot of scope.

You forget that the ISA gives full access to capital any time, while with the annuity the capital is completely lost. The ISA capital can also be invested for more tax-free growth, so as to beat inflation, whereas the level annuity will halve in value over 20 years.

dunstonh

You forget that the ISA gives full access to capital any time, while with the annuity the capital is completely lost.

No, I didnt forget that. If you look at post #3 you will see:

If you are looking to provide that income in retirement and capital is not a concern with this contribution, then the pension will provide the higher income.

The ISA capital can also be invested for more tax-free growth, so as to beat inflation, whereas the level annuity will halve in value over 20 years.

OMG its groundhog day!!!!

1 - can you guarantee that the ISA will provide a level of income and increasing annually? No you cannot.
2 - RPI or x% increasing annuities are available and would wipe the floor with ISAs over the medium to long term.