Pension contributions or ISA?

Cheer up! There might be a huge market crash before your 55th birthday so that the LTA won't matter at all.

In your shoes I'd be inclined to avoid as much 40% tax as I reasonably could, in fear of the 40% rebate vanishing after (or even before) the next General Election.

Would it be possible to defer the decision each year until after the Chancellor's Budget Statement in December?

noalibi wrote: »

I know this should be a simple numbers calculation question, but until the LTA, I've always thought pension contributions were the best way to save. I'm now thinking that I should consider other options.

The words 'simple' and 'LTA' don't really belong together in the same sentence. However, you can put a bit of a numerical framework around the decision, something that might help.

If you will be a basic rate taxpayer in retirement, then the pension is either better than or, worst case, the same as an ISA. Earn £100, put £60 into an ISA. Or earn £100, put £100 into a pension and then pay 15% blended tax (25% PCLS then 20% of 75%) on withdrawals below the LTA, or 40% blended tax (25% LTA penalty plus 20% of 75%) on withdrawals above the LTA. Any employer match and salary sacrifice uplift that you get with the pension but not the ISA pushes the benefit to the pension every time (albeit smaller once you pass the LTA).

If you will be a higher rate taxpayer in retirement, the calculus changes. Now you will pay 30% blended tax on withdrawals below the LTA, so still better than the ISA, but 55% tax on withdrawals above the LTA, and so worse than your 40% current tax rate. Again though, bolstered by any employer match and salary sacrifice uplift.

So the questions to ask are: Will you be a basic rate taxpayer in retirement?, What is the probability that you will exceed the LTA before retiring?, and Does the employer pension match and/or salary sacrifice uplift make up for the LTA penalty if you do?

The first question might not be as clear cut as you think. To keep from exceeding the LTA at age 75 and facing a steep penalty at that point, you will need to draw from your pension over 20 years (say). For a pension at LTA levels this means drawing around 6% annually (4% real growth and 2% inflation). So £60k with 75% of this taxable is £45k of 'earnings', and already right at the limit of the current 20% band. Any other income you have -- interest, dividends, BTL, part time work, whatever -- will then push some of this pension withdrawal into higher rate tax.

The second question is obviously tricky to answer, but you can guess by projecting some growth numbers, say 4% real, onto your current £800k and adding in expected new annual contributions up to when you plan to retire. At 4% real growth it looks to me like you might pass LTA in six years even without adding another penny to your current DC pension (1.04 ^ 6 * £800k = £1,012k), but do note that projecting over such a short timescale is going to be pretty guesswork-ish.

The third question is a bit easier. To equal the ISA you would have to get at least £60 back from the pension. If over the LTA and in higher rate tax, the tax rate on withdrawals is 55%, meaning you need a balance here of £133 to withdraw £60. So the employer match and salary sacrifice uplift on a £100 contribution from you would need to be £33. The best salary sacrifice uplift is perhaps 13% (employer NI), so if your employer can match your own pension contributions by 20% or more then the pension is always the better choice. Otherwise, you have a judgement call to make.

Of course, there is a fourth question also: How long before the government worsens the rules and/or moves the goalposts yet again? Nobody knows.

Painful, isn't it?

kidmugsy wrote: »

Mind you, reaching 75 would itself be a cause of celebration, as long as good health had survived too.

Indeed. But a 55% tax bill on a huge proportion of my pension is not the kind of 75th birthday present I have in mind as something to look forward to. I doubt the OP does either.

kidmugsy wrote: »

And if the OP doesn't reach 75 then the whole of his pension fund will be available tax-free to his nominee - for example his widow, say.

Pensions are certainly a great inheritance tax bypass. However, this is not what they are designed for. I suspect that at some point a future government will find this aspect of pensions inconvenient, and so axe it.

kidmugsy wrote: »

You're saying that a healthy real growth rate could cause LTA problems ... there wouldn't be much real growth generated by the part of his portfolio invested in ILGs but there could still be an investment performance that pleased noalibi.

That is not quite what I am saying.

The problem with the age 75 LTA test is that it captures all the investment growth since crystallising. Not just real growth but all nominal growth. Where initial crystallisation uses 100% of the LTA, there is no further protection from the LTA to be had at the age 75 LTA test, and so the entire nominal gain over perhaps two decades gets taxed at 55%.

The way to defuse this ticking tax time-bomb is to draw income that at least equivalent to the growth in the pension during the years between crystallising and age 75, where one's normal tax rate would be below 55%. More in this paper from Scottish Widows.