Approaching LSA - pension still the most tax efficient way to invest?

af1963

"IHT isn't a concern" ,  because ... ?

If it's because you don't mind paying IHT after you're both gone but still expect your estate to pay it, then it's possible that each marginal extra £1k that you add to the pension now ( costing you £800 net ) comes out as £480 or less paid to the eventual recipient, ( £1k minus IHT and then minus their own marginal tax rate)

If it's because you'll be leaving any extra leftover pension mostly to tax exempt recipients, charities etc, then £1k that you add now, costing you £800, will come out as £1k to the recipient.

If it's because you expect to spend the whole pension and savings, or at least down to IHT threshold, then it will depend how fast you choose to draw down the taxable pension whether you pay 20% or 40% tax on the extra £1k that you added.

GunJack

I still don't get it......if you're that well off you're paying some 40% tax, so what? Why limit your income to 50k if you could afford it to be 60k just because of a relatively small amount of tax?? It's still extra 6k nett a year...

artyboy

GunJack said:

I still don't get it......if you're that well off you're paying some 40% tax, so what? Why limit your income to 50k if you could afford it to be 60k just because of a relatively small amount of tax?? It's still extra 6k nett a year...

Because it starts to become more and more like a zero sum game - you realise that whatever new money you put into the pension will end up getting hit for the same tax rate on the way out. Yes there is also growth in the meantime, but that's also going to be taxed on withdrawal... so personally I'd rather have that outside a pension, either in an ISA or maybe a gilt ladder...

michaels

Gilts held to maturity often have low yields and thus low taxable income because effectively you make most of what should be interest as a capital gain at maturity but these gains are exempt from cgt. Hence the overall tax payable via a gilt ladder is considerably less than holding the same funds in an unwrapped savings account paying the same rate of interest.

This may be of relevance both to your existing unwrapped funds and also any pension withdrawals you make now to utilise not only the personal allowance but also the 20% band.

j2009

YellowCarBlueCar said:

So I'm struggling with whether the tax-free growth in the pension outweighs the income tax on withdrawal.

If you are referring to the growth on a pension because the money paid in isn't taxed (ie the pound amount invested is higher) then it makes no difference because the growth and tax are both percentages (commutative functions) so the order doesn't matter.

If you pay 20% tax now and you'll pay 20% tax when you draw down the only benefit to a pension is any employer contribution matching and the 25% tax free lump sum (so any money over the LSA isn't helping)

YellowCarBlueCar

Thanks for the continued comments.
To answer some of the questions, and ask a couple more...

IHT is the easy one - we have no dependants, and frankly when we're gone it's not going to affect us what happens to the remaining funds.  I'd like to think it might do some good, so will likely leave it to charities, so not an issue there anyway.

I've been thinking about the cash-flow modelling, and think the 'best' approach for me is to continue to model in "today's money" with the same growth and inflation assumptions as before, but to erode the personal and LSA allowances by the inflation amount.  I think this should model the scenario we're in right now where allowances are frozen and fiscal drag take their toll.  This will make the model comparable to my current one, which makes the numbers more relatable.

Yes, growth will take the funds over the LSA limit before drawing down in earnest - which is why I'm asking about the wisdom of contributing more.

It's also not a question of limiting how much to drawdown to avoid the 40% band, just a question of whether it would be better to not pay in with 20% relief and drawdown some at 40%.  Thank j2009 - I need to get my head around the tax on growth bit - at the moment it just isn't clicking in my mind, so I think I need to do some worked examples.

Still need to look more into Gilts!

I do realise that we're in a very lucky position, and have maybe reached the limits of the very generous tax allowances that pensions provide.  I'm not opposed to paying taxes - we all benefit from public services and they need to be paid for.

It does remind me a bit of Mr Burns - not a trait I want to cultivate!
https://www.youtube.com/watch?v=2xcYLVdfFro

EdSwippet

YellowCarBlueCar said:

So I'm struggling with whether the tax-free growth in the pension outweighs the income tax on withdrawal.

As already stated above, where the tax rates are the same the results are identical, because at 10% gains (say), 80% of 110% of £x is the same as 110% of 80% of £x.

The better question is whether tax-deferred growth in the pension beats annually taxable growth outside. Because here the tax rates can be different; specifically, dividends and capital gains have lower tax rates than income from a pension.

Taking a simple (and unrealistic) case. Suppose investments gain 7% over one year, 4% capital gain and 3% from dividends. On £70 of gain outside a pension, at basic rate tax you would pay 8.75% of £30 and 18% of £40 for £9.83 in tax. On £70 of gain inside a pension, 20% is £14 in tax on withdrawal. Investing outside the pension wins.

However, the annual tax outside the pension is a drag on compounding, which is tax-deferred inside the pension. This means there's a break-even point where the pension can start to win. So now the decision rests on how long you can leave this money inside the pension to compound.

And this is where things get tricky. Now you have to start modelling the future with spreadsheets or similar. There are multiple tax rates to consider, some of which may change, and usually not to your advantage, multiple inflexion points or other life changes, and also multiple assumptions about future growth, so that the possible outcomes branch ferociously.

For what it's worth, when I did this for my own case (back when the 25% LTA penalty was still a thing), I found my break-even on leaving my PCLS inside the pension compared to taking it now and reinvesting outside was likely to be around age 95. While this is technically a "win", it isn't a useful one.

YellowCarBlueCar

EdSwippet said:

However, the annual tax outside the pension is a drag on compounding, which is tax-deferred inside the pension. This means there's a break-even point where the pension can start to win. So now the decision rests on how long you can leave this money inside the pension to compound.

And this is where things get tricky. Now you have to start modelling the future with spreadsheets or similar. There are multiple tax rates to consider, some of which may change, and usually not to your advantage, multiple exit points or other life changes, and also multiple assumptions about future growth, so that the possible outcomes branch ferociously.

Thanks - this is where I've been struggling to compare - and you've helped to put down in words the thoughts I've been juggling with.

As you allude, the fact that so many of the modelling assumptions are unpredictable means that the outcome isn't going to be very reliable.

Apart from the obvious step of maximising ISA contributions, maybe I shouldn't get too hung-up on the tax implications if I'm looking at marginal differences.

j2009

YellowCarBlueCar said:

It's also not a question of limiting how much to drawdown to avoid the 40% band, just a question of whether it would be better to not pay in with 20% relief and drawdown some at 40%.  

I'm not sure I fully understand the question but if you pay money in with 20% relief and you then withdraw that money and pay 40% tax you are absolutely losing money; excluding I suspect the edge case where you're getting company matching. However, simplistically, growth does not factor into that decision as money can grow whether it's in a pension or not.

If this wasn't what you meant then please can you clarify?

Albermarle

OP - You posed an interesting question and got some good answers.

On a more philosophical note , I often think that one of the great advantages of being financially comfortable is not having to worry about money. So after no doubt decades of work, you have to consider how much time you want to spend on the detail of your finances, when you have already have far more than you need. 
Cash flow modelling, spreadsheets, dealing with tax on unwrapped investments etc etc
Some people love it and some do not.
Of course you can not totally ignore all possible issues, and money will always need some managing and time, but for some of us at least there is a limit.
Unless of course you are really like Mr Burns !
Although you seem quite relaxed about paying tax, and seem grateful for all the tax relief, so I guess you are not like him. 

Usually the main problem of many people on this forum is actually how to spend the money, after years of being careful.