ISAs v Pensions: The Official Retirement Debate

jem16

fairleads wrote: »

Yes EG it does and suffice it to say that the average GAD derived cap appears to be around 6.4%. Which means that annual income drawdown is limited to 6.4% of pension capital. Which in turn debunks the oft touted theory that SIPPS provide more income than that provided by discretionary capital - regardless of whether Isa-ed or not.

You're not comparing like for like here though. If I read you correctly you are saying that with drawdown you are limited to 6.4% income whereas with your ISA you can take whatever income you like. Obviously this is true but your ISA capital will erode more than the SIPP capital if you do this.

Basically what is meant is that if you pay in the same amount to a pension and an ISA you will be better off with the pension due to the tax free lump sum and tax free personal allowance.

And not to forget that pension income whether under drawdown or unsecured is subject to income tax whereas div income is'nt.

Dividend income is subject to income tax. For a basic rate taxpayer the tax credit fulfils the tax obligation but if that dividend income takes you above the age related allowance or into higher rate tax you will pay more tax.

Further, although cap gain in the SIPP is tax free, the gain remains in the SIPP, and although it increases the capital sum and thus the allowed drawdown, that extra income is taxable. Whereas me and the missus can realise 20K + gains taxfree each and every year -provided of course that our capital grows.

You and your wife also have a £20k tax free personal allowance at age 65.

dunstonh

According to my understanding if the SIPP capital takes a knock for one or two years then we can only draw a max of 6.4% of the now reduced capital.

What is this knock for one or two years?

You can draw a maximum of say 6.4% in this example but that doesnt matter as if you start taking amounts from any tax wrapper that is greater than 5% then you are risking capital erosion. The choice of tax wrapper isnt going to change that. You also need to remember that the pension value would be higher than the ISA due to tax relief.

If you put the same investments in the ISA and the pension or hold them unwrapped you will get the same returns with tax and withdrawal methods being the only difference.

fairleads

dunstonh wrote: »

What is this knock for one or two years?
You can draw a maximum of say 6.4% in this example but that doesnt matter as if you start taking amounts from any tax wrapper that is greater than 5% then you are risking capital erosion. The choice of tax wrapper isnt going to change that. You also need to remember that the pension value would be higher than the ISA due to tax relief.
If you put the same investments in the ISA and the pension or hold them unwrapped you will get the same returns with tax and withdrawal methods being the only difference.

Sorry, but I have never seen a comprehensive example, such as a spreadsheet, that proves the fact that we-d be better off saving in a SIPP. Many words but no actual substance. Yes, due to the tax rebates we might accrue more capital in the SIPP, but extra manco fees, as little as .5% p/a even, can reduce the capital growth significantly. Further, taking early retirement means lower PA thus more income liable for tax whereas div income is essentially tax free. The result is our net after tax SIPP income will be less than the div provided by the discretionary capital. In addition, in the case of emergency we are not limited to the amount we can draw - and most could be tax-free gain or taxfree capital - but SIPPers are, to 6.4% of capital. And if the SIPP yield is say 5% and the SIPPers drawing 6.4% of capital they are in effect paying tax on that 1.4% of capital.

dunstonh

but extra manco fees, as little as .5% p/a even, can reduce the capital growth significantly.

What makes you think the charges are more? Charges are generally standardised across the tax wrappers nowadays.

Further, taking early retirement means lower PA thus more income liable for tax whereas div income is essentially tax free.

divdend income is not tax free. Often with early retirement, people do phased drawdown and use that to provide a tax free income on the pension. Any dividends on the investments in the pension are then reinvested.

In addition, in the case of emergency we are not limited to the amount we can draw

the pension is not there to replace savings.

And if the SIPP yield is say 5% and the SIPPers drawing 6.4% of capital they are in effect paying tax on that 1.4% of capital.

I'm not quite sure what you are getting at there as the investment yields are the same irrespective of tax wrapper. If you are talking about income from the pension then remember it will be higher due to tax relief.

No one method/tax wrapper is suitable for 100% of your money. Its using a combination to get the best of all worlds.

The bottom line is that for income provision alone, pensions beat ISA.

fairleads

[The bottom line is that for income provision alone, pensions beat ISA.[/QUOTE]

Its not enough to keep repeating the above. Please substantiate this statement with figures.

dunstonh

fairleads wrote: »

Its not enough to keep repeating the above. Please substantiate this statement with figures.

They have been posted a number of times. Including on this thread.


ISA & pension have same investments and same charges. So, the only difference is tax and payment methods.

£80,000 in an ISA equates to £100k in the pension due to basic tax relief.

An ISA with a 5% withdrawal on £80k is £4,000 with no tax to pay.

Pension has two bits. 25% of that £100k is taken tax free = £25k
25k put into ISAs @ 5% pa withdrawal is £1250 a year
75k with 5% taken is £3750
Total income £5000

So, total income on the pension is £1000 a year more than just the ISA.

The income from the pension is potentially taxable depending on your personal allowance. However, even if its fully taxable then it would pay £3000 net plus £1250 from the iSA which is still £250p.a. more than the ISA.

If you take a typical person with around £4000 personal allowance free after state pension, then the ISA doesnt change at £4000 but the pension would be paid with no tax deducted as there is enough personal allowance free. So, the pension would pay £1000 a year more. So, using up the personal allowances of partner/spouse and your own pension makes sense.

All this is on this thread already.

jamesd

dunstonh wrote: »

Why? Income is higher than ISA even after tax and you have some personal allowance free.

Pension income is lower than ISA income during capped drawdown, if you're needing to draw at a higher rate than the GAD limit. That's a useful facility for those looking to make up the lack of state or perhaps work pensions when retiring before state pension age. The underlying return of the pension is higher, but the rate of drawing is what matters during that period and it's lower for a pension than for an ISA.

Whether the GAD limit is a factor will depend on gilt rates and age at which the income is to be taken, in part because it's possible to commence capped drawdown from 55 and save the income for later use, so those most adversely affected are those looking to retire fairly early or those who don't plan ahead and start drawdown before planned retirement age.

Even with the 18% lower GAD limit introduced by the current government there's still the tax relief and it's effect on making the pot size larger to consider. For those who can commence drawdown then retire after a few years of saving the income this can still give the pension the edge.

dunstonh wrote: »

The bottom line is that for income provision alone, pensions beat ISA.

fairleads wrote: »

Its not enough to keep repeating the above. Please substantiate this statement with figures.

I've already done so several times in this topic, including with spreadsheet results showing the income difference. See posts 269 and 403. However, I think that dunstonh's claim is inaccurate, because it needs a caveat about the GAD limit that it does not have.

Here's post 269:

jamesd wrote: »

Quotes from the Second Report of the Pensions Commission in 2005:

"Saving via a pension attracts significant tax advantages, not only relative to saving in fully taxed vehicles, but also relative to other tax-advantaged routes, such as ISAs. Most people achieve significantly higher rates of return if they make employee contributions into pension policies rather than save via other mechanisms;" page 25.

"for the median earner paying basic rate tax ... their pension is increased by 8% over that which could be obtained by saving out of post-tax earnings into an ISA, and by 17% over that which could obtained if they saved out of post-tax income into accounts subject to the normal rate of tax on investment income. This 17% advantage versus the “normal” tax treatment arises from three effects: the absence of tax on investment income during the accumulation period: the fact that the lump sum is tax free: and the fact that tax relief on contributions will for the average earner be at a marginal rate of 22%, while the pension received will in the case illustrated be taxed at an average rate of 17%. Such a person would however be even better off if she could persuade her employer to make employer pension contributions on her behalf, reducing cash wages but keeping the total labour cost to the employer unchanged. Figure 7.5 illustrates that in this case she is 30% better off saving through a pension than through an ISA, and 40% better off than saving in a non-tax privileged form" page 309.

"for the last 15 years the vast majority of household net financial savings has been via occupational pension funds, and that more than 100% of net financial saving has been in either pension funds or life policies [Figure 1.34]. Outside of pension funds and life policies, the household sector has been a net dissaver of financial assets. This is despite the growth of PEP/ISA accounts." page 82.

And the most interesting part of post 403:

jamesd wrote: »

Lets take a more realistic example, one I've fully worked and which pays the same net amount of money into pension and ISA. Send me a PM with an email address if you want me to mail you the spreadsheet.

Basic rate working and in retirement, monthly contributions of 300 increasing with inflation of 3%, growth 7% before inflation, after fees. £7,000 of state pensions, £10,000 personal allowance. Pension lump sum taken and invested in ISA (for simplicity assumed done in one year). 5% of capital available as income (drawdown in both cases). Here's how the two options compare for different numbers of investing years:

10 yrs pen  9609	ISA 9087
15 yrs pen 11286	ISA 10469
20 yrs pen 13063	ISA 12141
25 yrs pen 15213	ISA 14165
30 yrs pen 17813	ISA 16613
35 yrs pen 20960	ISA 19574
40 yrs pen 24767	ISA 23157

Clear enough: the after tax income from the pension is higher than from the ISA if you're putting the same amount of after tax income into each.

More detailed version:

10 yrs taxable pen  8956 net+lump income  9609 lump sum is 13043	ISA income is	9087	lump sum	41737
15 yrs taxable pen 10252 net+lump income 11286 lump sum is 21682	ISA income is	10469	lump sum	69383
20 yrs taxable pen 11820 net+lump income 13063 lump sum is 32134	ISA income is	12141	lump sum	102830
25 yrs taxable pen 13717 net+lump income 15213 lump sum is 44780	ISA income is	14165	lump sum	143295
30 yrs taxable pen 16012 net+lump income 17813 lump sum is 60079	ISA income is	16613	lump sum	192253
35 yrs taxable pen 18788 net+lump income 20960 lump sum is 78589	ISA income is	19574	lump sum	251485
40 yrs taxable pen 22148 net+lump income 24767 lump sum is 100983	ISA income is	23157	lump sum	323147

taxable pen: the taxable pension income from the 75% not taken as lump sum and the state pensions.
net+lump income: after tax pension income + ISA income from investing the lump sum. The full after tax income from the pension route.
lump sum is: the pension lump sum that is taken and invested in an ISA.
ISA income is: the ISA income plus the state pensions. The full after tax income from the ISA route.
lump sum: the ISA lump sum from which income is being taken.

---

For the pension the lump sum can be moved into an ISA. That substitutes some tax free income instead of leaving it all taxable. Since that lump sum is one of the big gains of the pension when tax rates are the same it's really necessary to handle it in the calculation.

1. Pension is: ISA from the lump sum, taxable state pensions and taxable 75% pension pot. ISA is: ISA pot, taxable state pensions (but no tax to pay because below allowance). All taxable income has had the right amount of tax deducted to get comparable after tax figures for pension and ISA.

2. The figures stop before the personal allowance reduction starts, so no. The pension lump sum being taken keeps the pension taxable income below it.

Any money that you put into ISA before pension makes you worse off in income terms before age allowance reduction starts.

Where you can gain from the ISA contributions is if you want to retire early. Then you can draw down 100% of the ISA capital to produce a higher income until the state pensions start. See this early retirement example which illustrates how the ISA part lets you take a higher income before state pensions. The ISA money lowers income longer term but its the way to go to boost income for the few years until the state pensions start.

Note that the calculations ignore the effect of the GAD limit on drawdown income, assuming that the limit will not be a factor. That is not true for those retiring close to age 55 and may often not be true for those retiring even at state pension age after the 18% reduction. At the time of the original post I didn't expect this to be a factor. With the lower limit I do expect it to matter more often.

Because of the GAD limit it may be necessary to plan to have a mixture of income sources so you can draw at the required rate, even though this will mean losing pension tax relief on the retirement income that can't be put into an actual pension.

dunstonh

James, I am working on the basis that someone wouldnt want to draw more than the GAD rate for their pension element. If they want to do that then they need to look at other provision as well. However, as you know on this thread (and many others in this section), the constant theme is that a mixture of pension and ISA is nearly always the best option. Not 100% into either.

If someone is looking to withdraw an amount that is likely to see capital erosion over the long term, then it clearly is going to impact on the calculations more than someone that is looking to take a sustainable amount.

jamesd

dunstonh wrote: »

I am working on the basis that someone wouldnt want to draw more than the GAD rate for their pension element.

The GAD limit is too low for that basis to be sensible for planning unless there is a clear commitment to retire only after state pension age, or a plan to take income before retirement but save the income for later use.

You really do need to add a GAD caveat; it's no longer high enough to be ignored now it's below the sustainable return from investments at many ages and only marginally above them in the early years after reaching state pension age.

The people who are most likely to be adversely affected are the ones who are planning for a long term sustainable income, which can require higher than GAD drawdown levels before the state pensions start and perhaps in the early years after that, until the GAD limit has increased enough for it to be imprudent to take income at that level.

Agreed about the need for a mixture of investments.

dunstonh

A 65 year old male can draw 6.8%.

It has always been considered prudent to draw less than 120%. So, the rule change from 120 to 100% isnt a big issue.

If someone is drawing more than 6.8% from an ISA then they are risking capital depreciation. Of course, risk profile, other assets etc all come into play but when anyone starts talking about regular withdrawals above 5% then that comes with risks.

So, on a like for like basis on a typical scenario the pension will beat the ISA. However, different scenarios may make alternatives better.

The people who are most likely to be adversely affected are the ones who are planning for a long term sustainable income, which can require higher than GAD drawdown levels before the state pensions start and perhaps in the early years after that, until the GAD limit has increased enough for it to be imprudent to take income at that level.

Which is why phased drawdown is expected to become more popular.