Both pensions and ISAs have been subject to radical reforms over the last few months, reopening the debate on where is the best place to save for retirement. So which is better? Does the pension's upfront tax relief trump the tax free growth within a new ISA (NISA), after the pension income has been taxed on the way out? And what if an individual's tax rates change between saving and retirement? We take a look at the numbers involved and the additional factors which come into the equation.
Firstly, what's new?
For pensions, from April 2015:
- It is proposed that anyone of pension age from April 2015 will have complete freedom to take as much (or as little) from their Defined Contribution (DC) pension savings as they choose.
- 25% will still be tax free. The balance will be taxed as income in the year it's taken.
- The annual amount that can be saved in a NISA will rise to £15,000 from July this year - an increase of over 30% on last year's allowance.
- In addition, there will be no cap on how much can be invested in cash within that allowance.
If the proposed changes to pensions are put in place, there will no longer be a restriction on what can be taken from a DC pension - just like a NISA - and the maximum savings into each are moving closer. These changes mean pensions and NISAs will become easily comparable as long term savings vehicles.
Crunching the numbers will show which will provide the best net return. But it's unlikely that the tax position of savers will remain constant, both at the point of saving and when it comes time to access those savings.
The tax breaks
Pensions and NISAs enjoy the same tax privileges on their underlying investments. Both investments pay no additional tax on any investment growth and income.
This gives them a distinct advantage over, say, a portfolio of collective funds (such as OEICs and unit trusts) where income will be taxed annually at the savers personal rate of income tax, and gains that may arise on switching investments could result in a charge to capital gains tax.
Where pensions and NISAs differ is on the tax breaks given when payments are made and when funds are accessed.
- Pensions enjoy tax relief on contributions. For a DC scheme, there will typically be a basic rate tax relief added to the pension fund, with any higher or additional relief claimed through self-assessment. So a £10,000 pension contribution will require a payment of £8,000. A higher rate tax payer would be able to claim a further £2,000 tax relief via their tax return and this will reduce the tax they pay on their other income. So the net cost to the investor paying higher rate tax is £6,000.
- There's no tax relief for payments into a NISA.
- Up to 25% of the pension fund can be taken completely tax-free. The balance is taxed at the saver's highest marginal rate of income tax.
- All withdrawals from a NISA remain tax-free.
The numbers 'crunched'
Assuming investments grow at the same rate for both pensions and NISAs, what would give the best net return? The table below looks at what could you get back from an investment of £15,000 out of post-tax earnings, left to grow over an investment period of 10 years. It covers each of the conceivable combinations of tax rates on the way in and the way out. To see how this works out in practice, see the Standard Life Pension v NISA case study.
1. Returns are based on a real rate of return of 2.5%.
2. Investments chosen under each plan are the same.
3. Neither pension payments in, nor withdrawals made, have any impact on the personal allowance.
4. Payments into the pension are made within the annual allowance.
5. Payments out of the pension don't attract a lifetime allowance charge.
6. Tax rates and allowances are at current levels.
So, in the majority of cases, the benefit of upfront tax relief with the ability to take a 25% tax-free lump sum will outperform a NISA on a like for like basis. The exception to this is a basic rate taxpayer funding a pension and paying higher or additional rate on the benefits. This situation could become more common under the new pension freedom if savers try to access their funds in large chunks. This is why advice on taking retirement income is essential.
More food for thought
There are, of course, many other factors that could influence choice between a pension or a NISA. The most obvious factor being that a NISA can be accessed at any age. There's no need to wait until age 55. A NISA could be preferable if you are saving towards a life event that is likely to occur before this age, or simply as a 'rainy day' fund. But that freedom could be an unwelcome temptation for less disciplined retirement savers.
Another point to consider may be what can be passed on to loved ones on death. A NISA will form part of the estate on death, unless the underlying stocks and shares qualify for business property relief. The rules for pensions are set to be reviewed as part of the ongoing consultation. The current situation depends upon whether individuals have started to draw benefits, or whether death occurs after age 75. The 55% tax charge, which can apply to some lump sums death benefits, is set to be cut and possibly replaced with either an IHT charge or income tax charge. Until the outcome of the consultation is known, the jury remains out on this one.
There remain strong arguments for having both pensions and NISAs together. And this may be the case where a large amount is needed for a particular purpose and taking it from the pension could mean that the income becomes taxed at either 40% or 45%. Having some savings and using them for large one-off expenditure could avoid income tax at the higher rates (and the loss of the personal allowance if income exceeds £100,000). As we'll show in a future insight, having a variety of investments can give some added retirement tax planning freedom. And it's NISA to have the choice!
Source: Standard Life Techzone