In this article, I want to illustrate why pensions are still the starting point for clients saving for their retirement. As you will know, an individual can make contributions with full tax relief and without any tax charge, up to the amount of their annual allowance. Provided it’s also within their Lump Sum Allowance (LSA), 25% of the amount withdrawn will be tax free. The residual amount is taxed at the client’s marginal rate of income tax applicable at the time. So, as long as the individual does not pay tax at a higher rate on the way out than on the way in, this will always create an “uplift” on the net amount invested.

The amount of uplift is illustrated in the table below. For example, a £10,000 contribution effectively costs only £6,000 where the client receives or has claimed 40% tax relief. If they pay no tax when they take the £10,000 out, their net contribution has effectively grown by 66.67%. If they are a basic-rate taxpayer when they make the withdrawal, the first 25% will be tax free while the residual amount will be taxed at 20% – resulting in net proceeds of £8,500 in this case. This still represents a 41.67% uplift. Even if they are still a higher-rate taxpayer when they take the money out, they will still receive £7,000 before any investment growth (an uplift of 16.67%). So, it’s clear to see the benefits of making pension contributions.

Pensions – personal contributions

Tax on withdrawal (25% tax free)

Tax rate No tax 20% 40% 60% 45%
None +25.00% +6.25% 12.50% 31.25% 17.18
20% +25.00% +6.25% 12.50% 31.25% 17.18
40% +66.67% +41.67% +16.67% 8.33% +10.41%
60% +150.00% +112.50% +75.00% +37.50% +65.63%
45% +81.80% +54.55% +27.27% 0.00% +20.45%

Please note: Figures after full tax relief reclaimed. This will differ for Scottish taxpayers.

ISAs vs. pensions

Over recent years, I’ve seen many articles that extol the tax efficacy of ISAs in terms of tax planning in retirement. This is often represented by “tax taps” to show how large income streams can be created in retirement without paying tax. However, I don’t think we should hoodwink ourselves into thinking that paying less tax in retirement - means that someone should be paying into an ISA when they still have pension allowances left.

It’s an obvious statement, but if a client pays £20,000 into an ISA, it’s worth £20,000. However, a £20,000 net contribution into a pension is worth – due to tax relief – £25,000 if the individual is a basic-rate taxpayer, £33,333 if they’re a higher rate taxpayer and £36,363 if they’re an additional-rate taxpayer. Over a 10-year period, and before any investment growth, this equates to £200,000 within an ISA and £363,630 within an additional rate taxpayer’s pension!

Of course, the client will not pay any tax when they take the money out of the ISA. If they withdraw £10,000, they’ll have £10,000 to spend. To realise the same net amount from a pension, they’ll have to take out more (assuming there is some tax to pay). As can be seen from the table below, a basic rate taxpayer will need to withdraw £11,765 while a higher-rate taxpayer will need to take out £14,286 (assuming 25% is tax free). However, there will be more money in the pension to start with.

Pension or ISA contributions?

Assuming client stays at same tax rate pre- & post-retirement

  £20,000 net contribution (after all tax relief reclaimed)
  ISA Pension
BRT (20%) £ 20,000 £ 25,000
HRT (40%) £ 20,000 £ 33,333
ADRT (45%) £ 20,000 £ 36,363
Withdrawing £10,000 net per annum (no growth)
Gross £ 10,000 £ 11,765* £ 14,286* £ 15,095*
Start £ 200,000 £ 250,000 £ 333,333 £ 363,363
5 Years £ 150,000 £ 191,175 £ 261,903 £ 288,161
10 Years £ 100,000 £ 132,350 £ 190,473 £ 212,685
15 Years £ 50,000 £ 73,525 £ 119,043 £ 137,211
20 Years £ 0 £ 14,700 £ 47,613 £ 61,736

*Based on 25% tax free and 75% at marginal rates

10 years (no growth)
ISA £ 200,000
Pension (BRT) £ 250,000
Pension (HRT) £ 333,333
Pension (ADRT) £ 363,363

Please note: This will differ for Scottish taxpayers.

If we assume the client pays the same rate of tax on the way out as the tax relief received on the way in – so, for example, they are a basic-rate taxpayer when the contributions are made and a basic-rate taxpayer when they make withdrawals – which wrapper produces the best result?

Quite simply, ignoring any investment growth, the amount within the ISA will last 20 years if £10,000 is withdrawn each year. However, if the client is a basic-rate taxpayer, they will still have £14,700 remaining within their pension under the same scenario – and it’s not until year 5 that the client has less money in their pension than the £200k net amount paid in. What’s more, a higher-rate taxpayer will still have £47,613 within their pension at the end of the 20-year period while an additional-rate taxpayer will have £61,736 remaining.

So, it’s important not to deceive ourselves that the efficacy of an ISA outweighs the efficacy of a pension, even if the client is paying tax on the way out.

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