Stuart Meiklejohn compares pensions and ISAs to see which is the most effective retirement planning tool
When basic rate tax reduces from 22% to 20%, pensions may no longer be the best way for basic rate taxpayers to save towards retirement - so claimed a recent article in the national press. Intrigued by this notion, I decided to take a look at the numbers.
Despite the newspaper's claims, I found that in terms of investment growth, pensions still have a significant advantage when saving for retirement - even for basic rate tax payers.
The maximum for ISAs is currently £7,000 pa, so this was the net contribution and income figure I used for both pensions and ISAs. I based the comparison on a net input of £7K p.a., payable monthly, for 20 years up to retirement - then a net income of £7K p.a. payable monthly, for 20 years in retirement. I used the charging structures we have in place for our ISA and SIPP to make the comparison.
This meant the gross contribution to the pension would be greater than for the ISA, which receives no boost from tax relief.
However, it also means a greater gross income coming out of the fund in drawdown, to produce the same net result. This tugs at an objection I have occasionally heard about pensions - "OK, they get tax relief on the way in, but the income is taxable on the way out". Does this really negate the benefit of tax relief?
Generally the example uses like-for-like assumptions and realistic charges and keeps non-relevant assumptions as simple as possible. I assumed no commission was payable and the same fund was used throughout. Also, I assumed the retirement income was all taken as drawdown with no tax free cash being uplifted.
In the accumulation phase, the pension fund grows at a faster rate than the ISA, because of the tax relief. The basic rate of tax relief assumed was 20% even though this does not actually reduce until April 2008.
For a high rate taxpayer the results are even more impressive but one drawback for high rate taxpayers is that the initial outlay is greater until the higher rate relief is reclaimed, as only basic rate relief is available at source. So for each £100 net contribution see table one (top).
After 20 years, the basic rate fund is an impressive 25% larger than the ISA fund. After consideration, this is not surprising given that (a) the SIPP enjoys a 25% greater contribution, (b) the admin charges in the SIPP are relatively insignificant and (c) the same investment fund is being compared so investment costs are neutral to the comparison).
On the same basis, the high rate taxpayer's fund is 66% ahead of the ISA but as above, the gross pension contribution after high rate tax relief is 66% more than the ISA.
So pensions win out during accumulation:
- There is no access to the pension fund until age 50 - (55 from 2010);
- If a customer contributes to an ISA initially, this can readily be recycled into a pension contribution later (watching out for the rules on tax free cash recycling);
- Pension income in retirement is taxable at your highest rate of income tax;
- The legislative limits for each tax wrapper may be relevant e.g. £7K limit for ISAs and for pensions, there is the annual allowance;
- Switching funds within the pension is free of charge and a cash fund/bank account is an accessible switching option within the SIPP.
Knowing that the income from pensions is taxable while income from ISAs is tax free, does that even things up in retirement?
For these calculations I assumed that if the pension contributor was a basic rate taxpayer on the accumulation phase, they will pay basic rate tax in retirement. Ditto for a high rate taxpayer. See table two (below left).
So the pension fund has to work harder than the ISA in retirement to generate the same net income. However, because the pension fund has had more contributions and more compounding growth on the extra fund, it is able to sustain its advantage ahead of the comparable ISA fund.
So the pension seems to win out again, especially for a high rate taxpayer. However, again there are further issues to consider, for example:
- The funds are treated differently for legislative and tax purposes like GAD limits on pension income, the relative position on death, inheritance tax treatment etc. Also, the rules covering alternatively secured pensions or annuity purchase mean less ability to pass funds to future generations;
- Tax rules may change in the future;
- The fact that 25% of the fund can be taken as tax free cash favours the pension. In this example, all the income has been draw, down from the fund. In reality, there could have been a greater saving by using tax free cash to generate some of the income;
- It was assumed that if a customer is a high rate taxpayer during accumulation, they would be a high rate taxpayer in drawdown. This may not be the case - they may only bear high rate tax on part of their retirement income, or even no high rate tax at all. The latter situation is the most efficient of all - high rate tax boost on the way in but only basic rate tax when drawing income.
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