Facts and analysis
On pure tax grounds when there is tax relief on the contributions, it is difficult to beat a pension. This is particularly the case for someone who is a higher rate taxpayer when making the pension contribution, but a basic rate taxpayer when they take the benefits. More is invested which means that the pension may benefit from growth on the tax relief, and it is invested in a tax efficient fund. When benefits are taken 25% is normally available as tax free cash, with the remainder taxable at the individual’s marginal rate.
An ISA also invests in a tax efficient fund, and although there is no tax relief on the contributions, all of the benefits are free of tax.
Let’s consider examples for basic and higher rate taxpayers –
- Assuming an initial investment of £10,000 and a net return of 4% per annum after charges
- Whole fund is taken as a lump sum after 10 years of investment
*Net contribution of £10,000, plus tax relief at the basic rate of £2,500
**Net contribution of £13,333, plus tax relief at the basic rate of £3,333. Client also reclaims £3,333 higher rate tax relief
The table illustrates that when you compare the 3 scenarios the pension will deliver the highest post tax return. There are, of course, other scenarios that you could consider, including that an individual could receive basic rate tax relief on the contribution, and then because the benefits are taken as a lump sum, that some is taxed at higher rates of tax. For example, if the basic rate taxpayer ends up taking the full taxable lump sum of £13,877 while still working full time and half of it falls into the higher rate tax band, the ISA would have been more tax efficient.
When choosing the best tax wrapper for an investment for a client, however, tax is not the only consideration. A pension is often not chosen on the basis of lack of access or because the investment is just not considered ‘retirement money’.
Pensions flexibility has gone some way to addressing issues of accessibility. For a client who is looking for a longer term investment, with no access to at least part of that investment prior to age 55, a pension should be considered along side ISAs as a suitable tax wrapper.
There are, however, a couple of important points to consider -
- Pensions can currently be accessed from age 55, but this is set to increase to age 57 in 2028 (when the State Pension age rises to 67), and then increase in line with changes to the State Pension age
- If a member flexibly accesses any taxable income from their pension this will restrict the amount of any future pension contributions. The money purchase annual allowance was £10,000 in 2016/17 and reduced to £4,000 in 2018/19.
Flexible ISAs enable an individual to take money out of the investment wrapper and then replace it. Prior to 6 April 2016 if a member needed to access money from their ISA the money could not be replaced unless there was some of the annual limit still remaining. Since 6 April 2016 an investor can replace money they have withdrawn from their ISA earlier in a tax year. For example, your client paid in £20,000 on 6 April 2018, but due to a subsequent emergency they needed access to £10,000 on 1 July 2018. The client will have until 5 April 2019 to replace the £10,000 in the Flexible ISA wrapper without affecting their normal annual limit. Please note that not all ISAs will offer this flexibility.
Mr and Mrs Collins are age 60 and both still working full time. They both have pensions with a total value of £500,000 and ISAs totalling £200,000.
They are about to move house to be closer to their daughter and new grandchild, and have found the perfect new home. They are in the fortunate position of having no mortgage, and are going to use the proceeds from the sale of their house to buy the new house valued at £200,000.
A couple of weeks before the move their own house purchase is delayed due to one of the buyers in the chain dropping out. It is thought that the chain will eventually proceed and their house will be sold, but unfortunately the owners of the house they want to buy are going to put it back onto the market unless they stick to the originally agreed sale date. Mr and Mrs Collins are keen to avoid taking out a bridging loan if possible and would prefer to use existing savings.
As both Mr and Mrs Collins are aged 60 it means that they can access their pensions. To reach the total of £200,000 they would need to take the maximum tax free cash of £125,000 plus a taxable lump sum for the balance. The amount of the lump sum will depend on the marginal rate of tax they will pay, but as they are both in full time employment it is likely that some of the lump sum will be taxable at the higher rates of tax.
This will generate the cash required to secure the new house purchase. There is then the issue of how to reinvest the funds received from the sale of their own house when this proceeds. If they have flexibly accessed the taxable income from their pension it means that the money purchase annual allowance will apply, which limits any future pension contributions. Consideration would also need to be given to the tax free cash recycling rules. This is going to make it very difficult to replace the funds into the pension.
Alternatively they could use the funds from their ISAs. If their existing ISA is not a flexible ISA they will need firstly to transfer it to a provider who does offer the flexibility. They can then withdraw the funds they need to secure the purchase of the new house. On the sale of their own house, they pay the full £200,000 back into the Flexible ISA so long as this all takes place within the same tax year. In addition they will still have the balance of any available annual limit for the tax year. Care would need to be taken that there is a clear expectation that the house sale will proceed within the same tax year so that the ISA funds can be replaced in full.