Post Budget: Pension or ISA?
with thanks to Technical Connections Ltd
So, relaxations to capped and flexible drawdown from 27th March this year, unrestrained pension drawdown from April next year and an increase in the ISA contribution limit to £15,000 from this July. Quite a package.
How, if at all, does this change the ‘ISA or pension’ choice for investors?
Well, it’s simple for those investors who cannot contribute any more to their ISA. And it’s simple for those who can’t contribute any more to their pension. Let’s not forget, in all the uncertainty, that the lifetime and annual allowance remain very much with us though. £40,000 for the annual allowance from 6.4.2014 (plus any unused carry forward relief) and £1.25m for the lifetime allowance subject to the various ‘protections’ available.
So assuming these limits haven’t been breached then 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, we are looking, post July, at up to £15,000 per investor. By the way, apparently, only one in ten ISA investors contribute 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. VCT and EIS have undoubted tax attractions but have very different risk considerations compared with a reasonably well spread and balanced portfolio underpinning a pension or ISA portfolio.
Let’s remind ourselves of the relative merits of the pension and ISA on tax grounds first – and on a chronological basis.
The most obvious difference on investment is that the investment into a registered pension will qualify for tax relief and an ISA doesn’t – and this can make quite a difference to the amount invested and working for you – in favour of the pension. And the longer the investment period the greater the impact this will have. 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 withdrawal? Well, 25% of the pension can be taken tax free – the PCLS. The rest (at least post 5.4.2015) could 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) would easily take a basic rate taxpayer into higher rates or even the additional rate. Of course, for the ISA, based on current legislation, anything withdrawn, however much, is tax free. This tax freedom and (relative – well as far as anything can be) tax certainty may be reassuring to many investors who are less than trusting over what future tax rates might be.
On pure tax grounds then, you need to ‘do the numbers’. The initial ‘tax relief’ boost that the pension delivers will make the pension take some beating. This will be especially so if one can secure relief at a high rate ‘going in’ to the pension but organise withdrawal (aside from the tax free cash) to only pay tax at a lower rate. Simple and effective ‘tax arbitrage’.
The reverse situation, low tax on investing and high tax at time of withdrawal will give the ISA appeal. You just have to do the numbers and be clear about the assumptions you are making.
Aside from these quantitative issues there are two other issues to consider. Before doing that though, it’s worth re-stating that it’s reasonable, we think, to assume that one could assume fund access and charge neutrality between ISAs and pensions.
So, to qualitative stuff. The standout is access. The ISA gives unconstrained access at any time. The pension doesn’t – not until age 55 and it looks likely that this age will ‘creep up’ to track ten years below the state retirement age.
So, 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.
And last, there’s inheritance tax.
The pension fund delivers IHT freedom on any death benefits paid at any time.
The income tax recovery charge of 55% on death benefits paid on post crystallisation funds still remains but there is to be consultation on the validity of this. 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 the right to the funds from the ISA were left to a spouse and taxable (if over the available nil rate band) if left to others. Of course, to the extent that the ISA is invested in BPR qualifying AIM stock IHT freedom would be achieved.
So, a lot to consider and advice, once again, will be essential taking into account all of the factors relevant to a particular investor.
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