The recent changes to both the Annual Allowance and the Lifetime Allowance means that pension saving should be attractive for just about everyone and when saving for retirement, a pension will in most cases provide better net returns than an ISA, purely based on the tax mechanics. In no cases will it provide a worse return, all other factors being equal.
Both pensions and ISAs enjoy tax free growth, but ignoring this, the relative attraction of the pension depends on three factors:
- Tax relief on the way in, ie on contributions
- The availability of tax free cash
- The tax rate on any taxable income that is withdrawn
All savers can now recommence pension contributions without the concerns of losing protection or incurring an LTA charge. This is a most welcome change. For some savers with already large pension funds, though, additional contributions may not generate any further tax free cash. Unless there is some form of protection the maximum tax free cash available will be 25% of £1,073,100, ie £268,275.
Despite this, a pension will still be the favoured option provided the tax rate on withdrawals is not greater than the rate of tax relief received when contributions are made. This is illustrated by comparing the returns from an ISA and a pension in different scenarios.
The cost of saving £1,000 into an ISA will always be £1,000 from net income, as there is no tax relief on the contribution. Assuming no investment growth or charges the eventual return would also be £1,000, as there is no tax on withdrawals. Thus ‘money in’ and ‘money out’ are the same.
The table below summarises the returns on a gross pension contribution of £1,000 (assuming no growth or charges) with:
- Different rates of tax relief on contributions
- Tax free cash available and not available
- Different rates of tax on withdrawals
| Tax relief on contribution | Net cost | Tax rate on withdrawal | Return with TFC available | Return no TFC available | |
| 45% | £550 | 40% | £700 | £600 | |
| 45% | £550 | 20% | £850 | £800 | |
| 40% | £600 | 40% | £700 | £600 | |
| 40% | £600 | 20% | £850 | £800 | |
| 20% | £800 | 20% | £850 | £800 |
So, for example, the net cost of a £1,000 contribution to a 40% tax payer is £600. If tax free cash is available and the tax rate on withdrawal is 20%, the total return will be £250 (tax free cash) + £600 (£750 income less tax at 20%) = £850.
This table illustrates that where tax free cash is available, there is always a positive return, even where the tax rate on withdrawal equals the rate of tax relief given on contributions.
The same is true even where no tax free cash is available if the tax rate on withdrawal is less than the rate of tax relief received on contributions.
Only where the tax rate on withdrawal is the same as the rate of tax relief on the contribution and there is no tax free cash available do the tax mechanics not deliver a gain. In this situation the outcome is neutral, which is the same as the returns from an ISA, but there are still arguments in favour of a pension being the preferred choice for retirement savings:
- Pensions are generally IHT free, and therefore more attractive when bequeathing wealth to the family.
- Pension savings can be passed on via inherited drawdown, which means that chosen beneficiaries can continue to hold their inheritance in a tax favoured wrapper. Only a spouse or civil partner can ‘inherit’ an ISA.
- Where pension savings are inherited on death after reaching age 75, they will be taxed at the beneficiary’s marginal rate of income tax, which may be lower than the member’s own tax rate. If the member dies before age 75, there may be no income tax at all.
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