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Pension vs Isa – getting the right tax wrapper for retirement

When analysing which wrapper is most appropriate for retirement planning, investors must compare the advantages of a pension with those of an Isa. The correct choice will depend upon a number of factors and no single solution will be right for everyone.

Consider the case of Rick Tyre. Rick has total income of £100,000 for the 2013/14 tax year. He has decided to make use of salary exchange and it has been agreed that his bonus of £18,880 will be paid into his pension.

His employer has also agreed to pay the employer National Insurance saving into the pension. This results in a total pension contribution of £21,485.

This course of action will result in a reduction in take-home pay for Rick that he could otherwise have received.

If Rick had received the bonus as additional remuneration, he would have lost his personal allowance but the pension contribution means that Rick remains entitled to the personal allowance which saves him tax of £3,776 (£9,440 x 40 per cent). The effective rate of tax relief on the pension contribution equates to 66.6 per cent as illustrated in the table below.

Effective of taking a bonus as a pension contribution rather than cash
Gross bonus £18,880

Tax @ 40%

(£7,552)

N.I. @ 2%

(£377)

Loss of personal allowance as a result of the bonus payment (£9,440 x 40%)

(£3,776)

Increase in take home pay if bonus taken as additional remuneration

£7,175

Gross pension contribution

£21,485

Effective rate of income tax relief

66.6%

Rick could therefore have a gross pension contribution paid of £21,485. 

Alternatively, he could decide to receive the bonus as additional remuneration and the net amount of £7,175 could be invested, for example, into an Isa.

Assuming a compound growth rate of 5 per cent a year, the Isa fund would be valued at £11,687 and the pension fund at £34,996 at the end of 10 years.

If Rick were to die before crystallising his pension fund, the pension provides 66.6 per cent more death benefit than the Isa if the estate is not liable to inheritance tax and 80 per cent more death benefit if the estate is liable to IHT.

If Rick survives until retirement, it could be argued that more tax-free cash can be taken from the Isa than from the pension.

However, if Rick secures the minimum income requirement, currently £20,000, he could withdraw the whole of his pension fund as a lump sum using flexible drawdown. 

It should be remembered that 75 per cent of the flexible drawdown fund would be taxable at his marginal rate of income tax.

Assuming that Rick remains a higher-rate taxpayer in retirement, flexible drawdown will provide an additional 52.29 per cent when compared to the Isa, as the table below illustrates.

Comparing funds available via flexible drawdown with an Isa
40% taxpayer Flexible drawdown ISA

Fund value at the end of 10 years (assuming a 5% p.a. growth rate)

£34,996

£11,687

Pension commencement lump sum

£8,749

N/A

Balance fund (net of 40% tax)

£15,748

N/A

Total net cash

£24,497

£11,687

If Rick were to become a basic-rate taxpayer, the flexible drawdown figures would improve further, providing 60.71 per cent more than the Isa – although Rick would need to ensure that the balance drawdown fund is drawn over at least two tax years to guarantee that his income does not fall into higher-rate tax.

If flexible drawdown is not a viable option for Rick, he could consider capped drawdown instead. The Isa would provide an additional £2,938 tax-free sum at retirement compared with the capped-drawdown option (£11,687 vs £8,749).

If we assume Rick is 65 when he invests into capped drawdown and the gilt yield is 2.5 per cent, the drawdown fund of £26,247 will provide gross income of £1,763. A gross return of 60.03 per cent a year on the £2,938 additional cash amount from the Isa would be needed to match the income generated by the drawdown arrangement.

Finally, the table below illustrates the situation on death if Rick dies shortly after transferring into drawdown.

Difference in fund values at death – pension vs Isa
  Capped drawdown ISA

ISA fund value at the end of 10 years assuming a 5% p.a. growth rate

N/A

£11,687

Value of crystallised PCLS in the estate at the end of 10 years

£8,749

N/A

Net of IHT @ 40%

£5,249

£7,012

Plus drawdown fund net of 55% tax based upon initial drawdown fund of £26,247

£11,811

N/A

Total return

£17,060

£7,012

It can be seen that the drawdown route also stands up well against the Isa option in the event of death. Even if there was no IHT to pay on the estate, the drawdown option would still provide £8,873 more to Rick’s beneficiaries than the Isa option.

Is it possible that the power of tax relief may just tip the scales in favour of the pension route for some individuals? Careful tax planning is needed on a case-by-case basis to ensure consumers are getting the most from their savings.

John Makin is a technical consultant at Axa Wealth

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