Many people get confused when talking about tax wrappers; such examples are (but not limited to) Pensions, ISAs, General (or Collective) Investment Accounts, and Investment Bonds.
As a side note, the lattermost tax wrapper shares its name with an investment asset – the bond. A bond is a form of debt, but further explanation isn’t necessary here.
So, what is a tax wrapper? It is first important to realise that the engine driving portfolio growth is the investment – not tax wrapper. For example, you could be invested in Apple, Meta or perhaps (and more usually) in an investment fund – such as one that tracks the FTSE 100, all of which aim to provide growth on your capital.
Regardless of the tax wrapper, the funds within a pension or ISA ‘belong’ to the pension scheme member / owner of the ISA.
Tax wrappers simply slot around the underlying investment to provide tax benefits. This is analogous to a car where the engine is moving the vehicle, but the body is needed to hold the engine in place; one cannot exist without the other.
Arguably the two most well-known tax wrappers are pensions and ISAs, but which is better from an economic perspective?
First, there is the question of income tax in retirement. Most people tend to pay basic rate tax or are non-taxpayers in retirement. Under that assumption, the above question can be answered.
If a non or basic rate taxpayer contributes £80 into a pension operating Relief at Source such as a personal pension plan, they will receive basic rate (20%) tax relief at source. Therefore an £80 contribution made by them will become £100 in their pension plan. Contributions to an ISA do not receive tax relief and so the net contribution would remain £80.
When withdrawing the money, there are different tax treatments between the two: ISAs enjoy tax free withdrawals, but only 25% of withdrawals from pensions are tax free – the rest is potentially taxable at your highest marginal rate.
Assuming no investment growth, the ISA payment received will be £80. However, for the pension with its less favourable withdrawal taxation, the situation is different. Assuming the individual is a basic rate taxpayer in retirement and is not subject to a Lifetime Allowance Charge, the withdrawal received will be the following:
- 25% of £100 as tax free cash = £25
- 75% of £100 less tax at 20% = £60
- Total = £85
Therefore, the pension will offer a higher amount after tax than the ISA (assuming the individual pays basic rate tax). For a non taxpayer the amount from the pension will be £100.
Furthermore, this does not take into account compound interest – which involves earning money on your original investment and earning money from any interest (or tax relief) that has been earned (or given). For example, within the pension vs ISA situation:
- If the investments in the pensions and ISAs grow by 10% (as the investments are exactly the same just in different tax wrappers)
- The ISA is therefore worth £88 and one can withdraw £88
- The pension would be worth £110
- £25% of £110 = £27.50
- 75% of £110 less tax at 20% = £66
- Total = £93.50
The difference between the two after growth is now £5.50 compared to £5 without growth (and compound interest). This may not sound like a lot (because it’s 50p in monetary terms) but, in percentage terms it’s 10% – which is more noteworthy.
Furthermore, the longer timeframe an investor compounds interest for, the larger this disparity between the two becomes. This is because interest is earning interest on more interest… and so on.
Therefore, over a long time period, a greater growth differential would occur. However, it is noted that periods of negative performance would reverse this effect and you may get less back (investing in both ISAs or pensions) than you invested. Nevertheless, over the long run, positive growth is expected but of course not guaranteed and the value of your investments can go down as well as up.
Though this could be the economically optimal solution between withdrawals and contributions to pensions and ISAs, there are many other factors to consider. For example, accessibility rules (normally 55 for the pension though this is increasing to 57 from April 2028), government legislation changes on tax rates, personal circumstances, large one-off withdrawal, change of personal tax circumstances, the Lifetime Allowance charge – to name a few.
If you would like more information on which option is right for you, please contact one of our specialist advisers who can tailor the best solution to your needs.