In considering this choice, the first point to note is that in the absence of tax considerations the return on an investment should be the same regardless of the ‘wrapper’ on the investment product.
Nevertheless, many people previously preferred to invest in ISAs because the whole of the fund could be drawn at any time, making an ISA more ‘flexible’ than a pension. With the removal of the restriction on drawing money out of a pension fund it is time to rethink that logic, because tax considerations can have a profound impact on the overall rate of return you get on your investment.
The following example, compares the net of tax returns on investment in an ISA and a Pension, for an individual who pays tax at the higher rate of 40% and can afford to invest £10,000 of pre-tax earnings:
There is no tax relief on contributions into an ISA, but growth in the fund is tax free, and there is no tax charge on withdrawal.
After tax at 40% on £10,000 income, our investor would be left with £6,000 to buy an ISA.
If the investment is left in the ISA for 10 years, at 4% growth per annum, the tax-free fund and net receipt at the end of year 10 will be £8,881.
There is tax relief on the contributions you make into a pension scheme (subject to limits), tax free growth within the scheme, but when you draw on the pension some of it will be taxed.
The first difference to note is that with 40% tax relief on pension contributions, the whole of the pre-tax £10,000 earnings ends up in your pension fund.
If the investment is left in the pension for 10 years, at 4% growth per annum, the fund will be worth £14802.
However, if the fund is drawn down, 25% would be tax free and the rest would be taxed at 40%, so the net receipt is £10,361.
In other words, the net of tax return on investment in a pension fund that is drawn is 16.67% higher than in an ISA.
But that is worst case scenario, because it assumes that the individual’s tax rate is 40% on investment and 40% when the investment is accessed, when in fact it is more often the case that the individual will only pay tax at the basic rate when they retire.
If the tax rate on retirement is 20%, the net of tax return on the investment in the pension would be £12,581, which is 42% more than the ISA.
Moreover, the benefits increase still further to the extent that you don’t ever draw down your pension but leave it to your heirs on your death. In that case, there is potentially no tax to pay on the fund (no Income Tax, no Capital Gains Tax, and no Inheritance Tax), so the return could be £14802, a full 66% higher than the ISA!
It is therefore clear that investing in a pension can provide a significantly better pension pot than saving via ISAs for the majority of people.
For further advice please contact Simon Turner, Chartered Financial Planner on 0114 266 4432 or email firstname.lastname@example.org.