Ideas for ISA Season: Have ISAs resurrected savings culture?
Until recently investors have always had a strong affinity to ISAs, almost an emotional attachment, something that cannot be said about Pensions. However once the new pension freedoms become embedded in public consciousness and assuming the Politicians will not be tempted to tinker with the changes, that maybe about to change.
If you set aside the greater complexities that exist in withdrawing funds from pensions and look purely at the tax merits of both, the result, I would suggest, should be a significant shift in the dynamics between ISAs and Pensions.
Taking these investment wrappers down to their base level, pensions are EET investment vehicles; contributions (E) are tax relievable, investment returns (E) are broadly tax exempt and withdrawals (T) are taxable. ISAs on the other hand are TEE; contributions (T) are not tax relievable, returns (E) are tax exempt and withdrawals (E) are tax exempt.
While the profiles may be different, an EET investment, everything being equal, will produce the same net result as its mirror image, a TEE investment.
For example, if we took a £10,000 pension contribution, that doubles in value over a given period, less 20 per cent tax, gives us £16,000. An £8,000 contribution into an ISA, (net of £2,000 income tax), doubling in value will give us the same £16,000 figure.
In reality it is more complex than this. The most notable issue is that the tax treatment on withdrawal is not purely T for pensions. Only 25 per cent of the pension pot is tax free with the remaining amount taxed at 20 per cent. Therefore, it is actually 25 per cent E and 75 per cent T which gives a very different result.
For example, a £20,000 pension pot minus the 25 per cent tax free sum leaves you with £15,000. If you then tax the remaining 75 per cent of the pension pot at 20 per cent tax you will receive £17,000 which is a 6.25 per cent uplift.
Primarily, this is why using a straight forward numeric comparison for pension investors over the age of 50 (assuming a 5 year investment term) comes out ahead of ISAs; a fact that is magnified further for higher and additional rate tax payers – 16.67 per cent and 20.45 per cent uplift respectively.
To address the issue fully it would also be appropriate to acknowledge a number of other factors that will influence the end result and ultimately the decision of the investor, these include:
- Tax rates may differ between inception and withdrawal. In all likelihood, this will be a lower rate on the way out, which favours EET over TEE. However, the reverse will apply if tax rates are higher upon withdrawal; a position that may arise outside of the investors control, under changes in tax rates or bands, or, pension rules.
- The calculations above ignore entirely the impact of national insurance contributions. This could be a significant boost for pensions over ISAs, particularly if you factor in a salary sacrifice.
- Pensions are subject to timing constraints on withdrawals that do not apply to ISAs. At present, this is age 55, rising to age 57 in 2028. Contribution and value limits apply to pensions; lifetime allowance of £1.25 million, and annual contributions of £40,000 per annum. While there is no similar lifetime constraint on the value of an ISA, there are contribution limits of £15,000 per annum.
- When it comes to distribution on death, within limited constraints, withdrawals from pensions should be largely free from Inheritance Tax, while the same is not the case for ISAs, unless, the underlying investment is that of qualifying AIM shares and these have been held for a minimum of two years.
In an ideal world, clients would have both a pension and an ISA, but where a choice can, or needs, to be made, the position is no longer as clear cut.