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ISA v pension: Which is better for a higher rate taxpayer?

Neil MacGillivray
Written By:
Neil MacGillivray
Posted:
Updated:
03/03/2014

Pensions and ISAs both offer tax breaks but which is the better savings vehicle for higher rate taxpayers?

As Budget Day approaches speculation regarding what changes will come into play is rife.

One subject which raises its head every year is whether or not individuals will continue to receive tax relief at their highest rate of tax on pension contributions.

The cost to the Exchequer of providing pension tax relief in 2011/12 was estimated to be £34.9bn, around twenty times higher than the cost of funding the tax benefits available on ISAs.

Though this is perceived to add fuel to the fire for those who wish to see pension contributions lose higher rate tax relief, it ignores the potential cost to the Government in the longer term if individuals are not incentivised to save for retirement; not only with respect to future tax take, but also the cost of care for those who have made little or no provision.

The impact of higher rate relief on contributions, with regard to the overall return on savings can be quite substantial.

For example, the table below shows the value of a person’s pension fund at the end of 40 years. For every £100 of net income saved monthly the gross amount saved per month will be £166.67 for a higher rate taxpayer. [The rate of growth is assumed to be 5% gross per annum and is calculated on a compound basis, capitalised annually.]

Return after 40 years per £100 net saved per month based on 5% gross return

Savings Higher rate taxpayer
ISA £148,856
Personal Pension £248,099

As is clearly demonstrated by this simple example, for a higher rate taxpayer the difference in return of almost a £100,000 between money saved in an ISA to that saved in a pension, may make them more likely to consider the benefit of contributing to a pension.

So what happens when the individual retires?

Taking income from an ISA is tax free, however pension income is taxable, though figures from HMRC indicate that 6 out of 7 individuals who were higher rate taxpayers during their working lives will be basic rate taxpayers in retirement.

Looking at the example in a bit more detail and presuming on retirement the individual took 25% of their ISA fund and the 25% tax free pension commencement lump sum to pay off debts and then took a net income of £7,200 pa (£9,000 pa gross from pension), increasing by 3% pa from the remaining funds, we see in the pie charts below that after 18 years the individual has received just short of £161,000 net income from both the ISA and personal pension.

However, the ISA fund is almost exhausted with only £6,689 left, while the pension fund has over £120,000 remaining. This could be used to continue to provide a drawdown pension or buy an annuity, if appropriate.

 

isa-image-1

pension-image-1

 

An alternative scenario is if the individual had died after 18 years and assuming their estate was liable to inheritance tax at the rate of 40%, then £4,013 would pass to their beneficiaries from the ISA. The remaining pension fund, though not subject to inheritance tax, would be subject to the special lump sum death benefit charge at the rate of 55% leaving £54,144 to pass to their beneficiaries.

A summary of the overall position is shown the table below:

  ISA Pension
Lump sum at outset £37,214 £62,025
Income over 18 years £160,954 £160,954
Funds remaining after all taxes £4,013 £54,144
Fund received net of taxes £202,181 £277,123
Total taxes paid £2,676 £106,415
Total fund value £204,857 £383,538

 

Even after income tax on pension income, and the lump sum death benefit charge on the remaining pension fund, the individual and his beneficiaries will have benefited from around £75,000 more from the pension than the ISA.

It has to be emphasised that this is only one example. How best to save for retirement and, of even more importance, how income is taken throughout retirement is a complex issue.

It should not be assumed that taking the maximum income from your pension is the best option; more than likely it may come from blending income from a combination of pension, ISA and other investments. What this example does illustrate though, is that the ability to defer any taxes until retirement is a benefit not to be ignored.

Neil MacGillivray is head of technical support at James Hay, a platform for retirement wealth planning

 

 


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