ISAs v Pensions: The Official Retirement Debate

EdInvestor

the point is that the fund starts with considerably more money and that will compound (the power of compound interest!) to a massively larger amount than you could ever achieve with post-tax pounds.

No. There is no advantage here.There is no compounding benefit on the tax relief - you are taxed on the income when it is paid.

You can take a 25% tax free cash lump sum: but against that, the rest of the capital savings are lost forever, except as a strictly limited income.

moneyandmountains

As EdInvestor says, stphnstevey is incorrect about gaining due to compounding on tax relief.
Without getting into age allowance etc., lets assume that the pension income is taxed at basic rate.

As an illustration lets assume an investment gain of 30% for a basic taxpayer.

£78 net invested in a pension, gives an investment of £100
Increase by 30% goes to £130

Now if the income is taxed at basic rate.

£130 becomes effectively £101.40

Now for the ISA
£78 net invested in an ISA
Increase by 30% goes to £101.40

Therefore, these are exactly the same.

However, if you take the 25% tax free sum from the pension.
So the £130 in the pension.
Take 25% i.e. £32.50 tax free leaving £97.50 in the pension.
Now assuming basic rate tax, £76.05 can be realised.

Therefore, if the 25% tax free sum is taken, the total pension benefit is 108.55
So, in this case the pension gives 7% more than the ISA, which isn't that much considering the lack of flexibility.

Additionally, if the pension income cuts into the age allowance, this benefit will swiftly be wiped out.

Of course, it is a different story for higher rate tax payers.

jamesd

stphnstevey, yes you can contribute to a pension for your wife. It's beneficial up to the first 10,000 of pension income, assuming good investments. So, government pension forecast for each of you first, then at least enough pension to top that up to 10,000.

stphnstevey wrote:

I know in a pension this is tax deffered till when you receive an income, but the point is that the fund starts with considerably more money and that will compound (the power of compound interest!) to a massively larger amount than you could ever achieve with post-tax pounds.

EdInvestor is correct that you are largely wrong about the initial accumulation mattering more, because you're taxed on it when you take it out of the pension. There are some cases where this is of benefit, though:

• The 25% tax-free lump sum from the pension. This is 25% of the after tax rebate amount so it does benefit from the rebate.
• The first 10,000 of retirement income, in the personal allowance, age allowance and 10% tax region.

For a basic rate tax payer when contributing it's harmful:

• When between around 20,000 and 25,000 of pension income because the pension reduces age allowance, ending up with an effective tax rate of around 33%, more than the 22% tax rebated when putting money into the pension.

The net result of these factors makes a pension good for a basic rate tax payer up to 10,000 in retirement income. Then it's fairly neutral between the two up to 20,000 and ISA is better from 20,000 to 25,000.

The tax-free lump sum is a pure benefit of the pension but it's effectively compensation for the loss of flexibility in the pension.

Someone who is only going to be able to get a pension of 10,000 (per person if a couple) might well be better off with most of their money in a pension and the ISA portion enough only for flexibility. This region is one where the pension tax benefits are clearly better than those for ISAs. If the person is also interested only in low risk they are likely to buy an annuity and the extra flexibility of the ISA will matter less to them.

But it's vital that the pension is well invested - a pension with poor fund choices just won't deliver the investment growth and an ISA could easily be better than a limited pension.

This post is basically just an expansion of the "use a pension for the first 10,000 per person of retirement income" general rule.

moneyandmountains

I have put a few figures through the tax calculator at http://www.listentotaxman.com/
Now assuming that site is correct for people aged 65-74 (someone may want to check).

£10000 grosss pension income goes to £9659 after tax. Decrease by 3.4%
£15000 gross pension income goes to £13559.60 after tax. Decrease by 9.6%
£20000 gross goes to £17459.60 after tax. Decrease by 12.7%
[STRIKE]£25000 gross goes to £21359.50 after tax. Decrease by 14.5616%[/STRIKE]


Previously, it has been shown that there is no compounding of tax advantage on pensions.
So, an pension with no tax free sum taken will be 22% up on a comparable ISA before income is taken.

The figures above seem to suggest that if the gross pension income is £10000,then the advantage of the pension is
22 - 3.4% = 18.6% pension advantage


[STRIKE]However, for a 25kpa pension this is reduced to 7.4% advantage.[/STRIKE]

Obviously, this is assuming that tax allowances are not used by savings/other income.

Note: Taxable pension income includes that from the state pension.

jamesd

nobodieshero, you risk having to use your ISA investments to provide your income if you are unemployed and their effect on means-tested benefits but if those don't apply to you then your plan is fine, particularly if you do end up in the 40% tax band and can make large enough pension contributions to take you back down to basic rate.

You aren't losing growth on the 22%. It's just an illusion. You really get the growth on the non-22% portion then that is magnified by the 40% at higher rate, so you gain more than you have lost by that extra 18% difference when you do make the contributions at higher rate.

A fair plan is to wait until higher rate then make contributions to take you to the top of basic rate, switching money from ISA to pension if that seems useful. It may take a while before your higher rate income is large enough to make this useful, since you do only get relief on the portion of your salary contributed above the basic rate limit.

jamesd

moneyandmountains, it's worth adding in the effect of taking the maximum 25% tax-free lump sum, since it's a pure benefit of the pension.

Also, the marginal rate from 20,000 to 25,000 is the interesting number there, not the total rate for the whole 25,000:

£20000 gross goes to £17459.60 after tax.
£25000 gross goes to £21359.50 after tax.

Increase in income when going from 20k to 25k = 3899.90 = 78%. This strongly suggests that the site is NOT including age allowance reduction in its calculations. So it's not reliable above 20,000.

moneyandmountains

Ok.
After checking, I understand that age allowance reductions apply for incomes of over £20100

So for gross income of greater than £24590, the personal allowance is reduced to £5035 (the same as a person under 65).

This means that for a £25000 gross income, the net income is £18670.54
which is a reduction of 25.3%

So, for a 22% initial tax relief, the £25000 pension (without 25% tax free sum) is 3.3% down on an equivalent ISA.

With the 25% tax free sum taken, the original figures apply as the remaining pension is below the age allowance reduction.

Help the Aged has a more eloqeuent way of putting this, see:
http://www.helptheaged.org.uk/en-gb/AdviceSupport/FinancialAdvice/Tax/CheckYourTax/as_checktax_190106_3_a.htm

Paul_Herring

stphnstevey wrote:

I know in a pension this is tax deffered till when you receive an income, but the point is that the fund starts with considerably more money and that will compound (the power of compound interest!) to a massively larger amount than you could ever achieve with post-tax pounds

Wrong. So very, very wrong. If this is the only reason you're chosing and ISA over a pension, or vice versa, this is very wrong.

For this particular reason (i.e. tax) THIS IS NOT A REASON TO CHOSE A PENSION/ISA over the other.

http://www.fool.co.uk/school/2005/sch051219.htm

Fool wrote:

For example, look at the position for a higher rate taxpayer who earns £100 gross (that is, £60 after tax), saves it and gets 9% growth for three years before drawing income at a rate of 5%. Each year's income will be the same, for the ISA and the pension:

ISA: 60% x £100 x 1.09 x 1.09 x 1.09 x 0.05 = £3.89

Pension: £100 x 1.09 x 1.09 x 1.09 x 0.05 x 60% = £3.89

stphnstevey

moneyandmountains wrote:

As EdInvestor says, stphnstevey is incorrect about gaining due to compounding on tax relief.
Without getting into age allowance etc., lets assume that the pension income is taxed at basic rate.

As an illustration lets assume an investment gain of 30% for a basic taxpayer.

£78 net invested in a pension, gives an investment of £100
Increase by 30% goes to £130

Now if the income is taxed at basic rate.

£130 becomes effectively £101.40

Now for the ISA
£78 net invested in an ISA
Increase by 30% goes to £101.40

Therefore, these are exactly the same.

Your right, after doing the numbers, even after say 10 yrs, it still works out the same - interesting..... Must be due to tax being a % and not a fixed amount. Now truly understand why pensions reffered to as 'tax deffered'. Unless your tax situation changes in retirement...eg. personal tax allowances and 25% tax free or you get 'free' money from an employer contribution.

Paul_Varjak

jem16 wrote:

The pension wrapper can be ideal for the higher rate taxpayer who will be a basic rate taxpayer in retirement. 40% relief going in and 22% coming out.

For people like me - nil rate tax payers now and 10% rate in retirement, Pensions also have some benefits as Basic Rate tax can still be reclaimed on contributions into pensions by non-taxpayers.

I pay £2,808 each year into a pension fund and this is grossed-up to £3,600 with a tax rebate.