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Is three a crowd?

The pension versus Isa debate has raged on and off for years. Les Cameron, head of technical at Prudential, asks if three’s a crowd.  

I think the debate was arguably settled by pensions freedom when the biggest downside of pensions – limited access and poor death benefits – was fundamentally changed. Total access, albeit with potential income tax implications and better death benefit taxation, was in my view a debate settler.

There are of course several considerations in the debate, and a particular set of client circumstances may make the choice simple. I usually start off with a certain premise. When asked if they would rather have 100 per cent of £80 or 85 per cent of £100, the overwhelming majority of people would choose the latter. £85 is more than £80; I’ll have the one that gives me the most money!

That to me is the fundamental starting point. If you put £80 in an Isa, you get that back. A basic-rate taxpayer puts £80 in a pension; they get a 25 per cent government top-up (that’s what basic-rate tax relief is, after all), making it £100. With tax-free cash meaning only 75 per cent of this is subject to basic-rate tax (£15), you get £85 back. Different tax situations give different answers but there is one simple rule.

The tax wrapper that has the greatest differential between the tax relief on entry and tax payable on exit returns the most money.

With the Isa, there is no tax relief on the way in and no tax on exit so that differential is 0 per cent. In the basic-rate taxpayer example above, the differential is +5 per cent (20 per cent minus 15 per cent) as the tax-free cash reduces the effective rate of tax on exit by 25 per cent.

So, while acknowledging there are potentially many different moving parts to the pension/Isa decision, if access is required pre-55, Isa wins – you’d not normally have access to your pension pre-55. If it’s post 55, the pension wins. Where there is any sort of positive tax differential, which should be the norm, not many people go up a tax bracket as they enter retirement.

In a nutshell, the one that gives the highest net return at the point the money is required wins.

And now we need to have a fresh look at the pension/Isa debate with the new Lifetime Isa (Lisa) on the horizon. And it effectively has tax relief on entry and potential for ‘tax’ on exit.

So, a quick look at the mechanics of Lisa, then we can get back to the debate.

The Lisa is a new variant on the Isa theme. This one is designed to encourage younger savers, and help with the dilemma of whether to save for the first home or retirement, by catering for both!

Here are the facts as they stand (at time of writing it’s still a bill and being debated in Parliament) as at 12 December 2016.

General

It basically has all the same things as a ‘normal’ Isa: no tax on income or gains, the allowable investments are the same, it will be in your estate for IHT unless business relief qualifying assets are held, it will be available for creditors and can be transferred between different Lisa managers, etc, etc.

Contributions are made from post-tax income, and withdrawals, subject to certain conditions, will be tax free.

However, given the government top-up, there are some key differences.

Eligibility

From April 2017, UK residents and Crown employees and their spouses or civil partners, aged between 18 and 40, can have one.

Contribution limit

Contributions are limited to £4,000 per tax year.

This counts towards the overall Isa allowance of £20,000 from the 2017/18 tax year.

For the 2017/18 tax year only, any Help to Buy Isa funds saved before 6 April 2017 can be transferred into a Lisa without the value counting towards the Lisa contribution limit. Thereafter any transferred-in funds will count towards the allowance.

Government bonus

Contributions made from the age of 18 up to the age of 50 get a top-up.

The top-up is stated as 25 per cent and is the equivalent of basic-rate tax relief on a pension, i.e. £80 becomes £100.

For 2017/18 any Help to Buy Isa funds transferred in will qualify for the bonus.

The bonus will be claimed directly from HMRC by the provider of the Lisa.

For 2017/18 this will be at the end of the tax year; thereafter it will be monthly in arrears.

Withdrawals – penalty free

The Government can make regulations on the purposes for which monies, including any bonus, can be withdrawn without suffering the penalty outlined below.

These are currently:

  • any reason after age 60,
  • to buy a first home worth up to £450,000 at any time (conditions apply) from 12 months after first saving into the account,
  • on death, and
  • on terminal illness, where life expectancy is under 12 months.

Penalty access

Where withdrawals are not penalty free, there is a government charge of 25 per cent of the amount withdrawn. This is intended to recover the government bonus including any growth with a ‘small additional’ charge.

You could liken this to a tax on unauthorised withdrawals as it has the same effect as tax. It reduces the net return.

The ‘small additional’ charge is actually 6.25 per cent when you run the numbers:

  • Put £4,000 in and get the £1,000 bonus
  • Charge = 25 per cent x £5,000 = £1,250
  • Net return = £3,750
  • Difference between amount invested and amount returned = £250
  • £250/£4,000 = 6.25 per cent

The charge will normally be paid directly to HMRC by the Isa provider.

‘Special rules’

There are some tweaks being made to the rules for 2017/18. There will be no government charge on withdrawals from Lisas. However, if an individual wants to withdraw from the Lisa in 2017/18 for any reason other than terminal illness, they must fully close the account. Doing so will essentially cancel that Lisa account. There will be no government charge due on the closed account, but there will also be no bonus paid on it at the end of the tax year. You could open a new Lisa later on in that tax year if you wished, without it contravening the Isa rules.

So that’s it on the new entrant to our debate, which brings us back to the debate itself. The  underlying premise is that, broadly speaking, it is sensible to invest in the thing that gives you the highest net return at the time you need it.

The determinant of highest net return is the entry/exit tax differential. All the wrappers should have broadly the same tax treatment and charges while invested.

The table shows these tax differentials for our options:

Tax status Tax differential
Entry Exit Isa Lisa
with penalty
Lisa
penalty free
Pension after tax and PCLS
0% 0% 0% -5% 20% 20%
20% 0% 0% -5% 20% 20%
20% 20% 0% -5% 20% 5%
20% 40% 0% -5% 20% -10%
40% 0% 0% -5% 20% 40%
40% 20% 0% -5% 20% 25%
40% 40% 0% -5% 20% 10%
45% 20% 0% -5% 20% 30%
45% 40% 0% -5% 20% 15%
45% 45% 0% -5% 20% 11.25%

Note the monetary return will be different from the tax differential above, as per the example for 6.25 per cent monetary loss for the 5 per cent ‘small additional’ charge.

Where the pension/Isa debate could be summed up as when you want access, the change as I see it with Lisa coming along is when you want access and what you want access for.

As can be seen in the table above, a penalty-free Lisa is very attractive in most tax scenarios. It will always beat an Isa and normally be better than a pension. Where it is equal with the pension you would probably favour Lisa as there is unlimited tax-free access and no need to manage tax bands. However, the secondary considerations may then become the main driver to decide.

A post-penalty Lisa is the opposite. It’s not looking good other than in the most unusual circumstances.

This is just number crunching, of course; there will be other considerations. Will pensions change? The IHT/access to creditors advantages of pensions would seem to be a second-order consideration at most times, but probably all the time for an 18- to 40-year-old. On IHT, perhaps grandparents or parents could be the ones doing the funding as part of their IHT planning? Helping your young ones onto the housing ladder with a government top-up while reducing your IHT bill would appear very attractive.

Probably the biggest consideration will be: how will the FCA view Lisa instead of a matched employer contribution? It seems a bit like a pension opt-out situation to me. Permissions would be needed for advising on a Lisa where workplace pension contributions stopped as a result. And, of course, if you have generous employer matching, pension will win the numbers game above all the time.

So where does Lisa fit? I’m sure the debate will develop as the bill winds its way through Parliament and we won’t have heard the last of it.

Is three a crowd? There are myriad options when it comes to financial planning and there will most definitely be a place in the crowd for Lisa. In general, all you need to do is find an 18- to 40-year-old with disposable income who wishes to save and has yet to buy their first home, or is definitely of the opinion they will not need the money until they are over 60.

View Prudential’s hub for tax year end planning and support.

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