The key question anyone asking themselves when investing for the long term is whether to stash money away in a pension or an individual savings account. With the annual Isa allowance being raised to £15,000 on 1 July you might think that any wealthy person investing for growth would want to max this out to the full and gain the benefit of full access to capital while investing for growth, followed by tax free fully flexible income in retirement.
However, following changes announced in the Budget 2014 that come into place next year, pensions will have no restraints on the flexibility over the level of income withdrawn in retirement – though the capital is still tied up until age 55. And exclusive research by an independent financial advice firm for Investors Chronicle concludes that, overall, the goal posts have moved firmly in favour of the pension.
With access to investors’ pension money expected to open up from April 2015, Lowes Financial Management says pensions are now on a level playing field with Isas. They modelled the same amount of money invested in a pension and an Isa over various periods and then taken as income to see how long the money would last. They found that pensions give better returns than Isas at several different valuation points, ages and income tax rates.
The research looks at saving over different periods, with contributions to an Isa and a pension of £1,200 net per year, escalating by 3 per cent a year to age 65. Starting at age 65, investors take £10,000 net income a year, escalating by 3 per cent a year. All pension income is taken as 25 per cent pension commencement lump sum and 75 per cent as taxable income. Growth on both schemes is assumed at 6 per cent a year net of charges. The research then looked at the funds remaining at age 75.
The most efficient way to take income, in order to avoid current pension taxes on death benefit lump sums, is to take 25 per cent as pension cash lump sum, and the remaining 75 per cent as taxable income. ‘Flexible’ drawdown allows this already, after £12,000 guaranteed annual income, but this will be open to all next year and so this is what Lowes' calculations have been based on.
Pensions vs Isas
Pre-retirement income tax rate | Post-retirement income tax rate | Fund value remaining at age 75 | |||||
| Saving from age 35-65 | Saving from age 45-65, plus £15,000 initial contribution | Saving from age 55-65, plus £30,000 initial contribution | |||||
| ISA | Pension | ISA | Pension | ISA | Pension | ||
| 0% | 20% | £102,831 | £76,541 | £43,558 | £17,268 | £0 | £0 |
| 20% | 0% | £102,831 | £165,783 | £43,558 | £91,691 | £0 | £13,711 |
| 20% | 20% | £102,831 | £139,492 | £43,558 | £65,401 | £0 | £0 |
| 40% | 20% | £102,831 | £244,412 | £43,558 | £145,624 | £0 | £41,650 |
| 40% | 40% | £102,831 | £206,855 | £43,558 | £108,067 | £0 | £4,093 |
| 20% | 40% | £102,831 | £101,935 | £43,558 | £27,844 | £0 | £0 |
Source: Lowes Financial Management
Notes: These figures show what is left of the pension/Isa pot at age 75. For example, a 35 year old contributes to the savings schemes until they are 65 and is taxed 40 per cent on the way in, 20 per cent on the way out. From 65, they take £10,000 net income per year escalating by 3 per cent per year. The funds remaining when they are 75 in the pension are higher at £244,412, compared with £102, 831 in the Isa.
Inheritance Tax and lump sum pension taxes are not accounted for in these figures.
The most common tax scenario for investors is to be a 40 per cent tax payer pre-retirement and a 20 per cent tax payer post-retirement. According to Lowes, this tax scenario would lead to double the money left in the pension at age 75 than in the Isa.
For example, a 35 year old contributes to the savings schemes until they are 65 and is taxed 40 per cent on the way in and 20 per cent on the way out. From 65, they take £10,000 net income per year, escalating by 3 per cent per year. The funds remaining when they are age 75 in the pension are higher at £244,412, compared with £102,831 in the Isa.
Lowes Financial Management technician Barry O’Sullivan says: “Tax relief ‘on the way in’ is a valuable part of a pension’s overall return.”
The compound effects of growth on the tax relief element of pensions mean that returns are normally higher in the pension, when compared with an Isa. However, even though 75 per cent of the pension is taxed on the way out, compared to tax-free Isa withdrawals, the pension still wins overall.
“The only circumstances where someone would get less of a benefit from pension saving, in theory, are those who have a lower income tax rate while they are earning than they will in retirement,” says Mr O’Sullivan. “These will be few and far between though.”
Despite these conclusions, younger people need to bear in mind that they face later access to private pensions than their parents. At present, pensions money cannot be accessed until age 55 and there are plans to raise this minimum age in line with scheduled increases in state pension age. Someone aged 35 today will not reach state pension age until they are 68 and would not be able to access a private pension until age 58. There is also the possibility that future governments may reintroduce restrictions or the insistence that an annuity of some sort has to be purchased. Also, tax relief on pension contributions may be reduced in future.
Isas better for inheritance tax
The Lowes models do not account for how your money is taxed when you die, which may be important if you are planning on leaving an inheritance.
When you pass away it pays not to have your money in a pension, because any lump sum from a pension will be charged at 55 per cent tax. However, if you hold the money in an Isa account, you will only suffer tax at 40 per cent on amounts above the £325,000 inheritance tax threshold.
Isas can also be used to buy Aim-listed company shares, which are exempt from inheritance tax if held for two years.
However, the Treasury has launched a review of the 55 per cent tax which is levied on pensions left in drawdown on the death of the retiree.
In the Budget documents the Treasury said: “The government wants to ensure the current tax rules that apply to certain pensions on death continue to be appropriate under the new system. In particular, the government believes that a flat 55 per cent charge will be too high in many cases in the future.”
