The big Budget changes to pensions and Isas mean that advisers may need to review the fundamentals of this key decision on wrapper choice.
We have relaxations to capped and flexible drawdown from 27 March this year, unrestrained pension drawdown from April 2015 and an increase in the Isa contribution limit to £15,000 from July. That is quite a package.
How, if at all, does this change the “Isa versus pension” choice for investors?
It is simple for investors who cannot contribute any more to their Isa or pension. Remember, the lifetime and annual allowances remain very much with us: £40,000 for the annual allowance from 6 April 2014 (plus any unused carry-forward relief) and £1.25m for the lifetime allowance, subject to the various protections available.
Assuming these limits have not been breached, the choice arises in relation to any surplus capacity over the current Isa contributions being made by the investor. Given that there is no carry-forward of Isa contributions, the limit, from 1 July, will be £15,000 per investor. Note that reportedly, only one in 10 Isa investors contributes the maximum.
In making our comparison, we will assume that pensions and Isas are the tax no-brainer choices. We will not consider other investments, such as insurance and collective-based investments. VCTs and EISs have undoubted tax attractions but very different risk considerations compared with a reasonably well-spread and balanced portfolio underpinning a pension or Isa.
Let us recall first the relative merits of pensions and Isas on tax grounds.
The most obvious difference is that investment in a registered pension scheme will potentially qualify for tax relief but investment in an Isa will not. This can make a notable difference to the amount invested and working for you – in favour of the pension. And the longer the investment period, the greater the impact. Assuming investment and charge neutrality, which is reasonable, the pension could generate quite an advantage.
Both pension and Isa funds are, of course, tax-free in relation to income and capital gains generated.
So how about withdrawals? Twenty-five per cent of the pension can be taken tax-free as the pension commencement lump sum. The rest (after 5 April 2015) can be taken at once, or in instalments, in cash subject to the investor’s marginal rate of tax at the time of drawdown.
Chunky withdrawals (especially the whole fund) could easily take a basic-rate taxpayer into the higher rate or even the additional rate. There is unlikely to be top-slicing relief.
For the Isa, based on current legislation, anything withdrawn, however much, is tax-free. This tax freedom and relative tax certainty may reassure many investors who do not trust future tax rates.
On pure tax grounds, then, you need to do the numbers. The initial tax relief boost delivered by the pension means this product will take some beating. This will be especially the case if one can secure high-rate relief for contributions to the pension but organise withdrawal (aside from the tax-free cash) to pay tax only at a lower rate.
The reverse situation – no tax relief on investing but no tax at time of withdrawal – makes the Isa appeal. You just have to do the calculations and be clear about the assumptions you are making.
And one can reasonably assume fund access and charge neutrality between Isas and pensions.
Access all areas?
Having reviewed the quantitative issues, there are two qualitative factors to consider, of which the standout is access. The Isa offers unconstrained access at any time. The pension does not, until age 55, and this age is likely to creep up to track 10 years below the state retirement age.
How important is this? If the pension scores on the numbers but access at any time is important, being clear on the numbers will allow you to put a price on access before age 55.
Finally, there is inheritance tax. The pension fund delivers IHT freedom on any death benefits paid at any time.
The income tax recovery charge – 55 per cent on death benefits paid on post-crystallisation funds – remains in place but there will be a consultation on its validity. One could see this falling to the level of the individual’s marginal rate to match the proposed charge on withdrawn funds.
Isas are non-assignable and the full value would be included in the estate of the investor. The IHT position would depend on who the funds were left to: IHT-free if left to a spouse but taxable (if over the available nil-rate band) if left to others.
Of course, to the extent that the Isa is invested in IHT business property relief-qualifying Aim stock, IHT freedom could be achieved.
Tony Wickenden is joint managing director of Technical Connection
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