To ISA Or To Pension? That Is The Question!

An examination of the tax virtues of making ISA or Pension Contributions.

1. Pensions 

Contributions are tax relieved.

Returns within the pension are tax free.

Withdrawals from the pension are taxable.

2. ISAs

Contributions receive no tax relief.

Returns within the ISA are tax free.

Withdrawals from the ISA are tax free.

The Theory

In theory, a Pension and an ISA should produce the same net end result; providing tax rates do not change from entry to exit.

For example, if a £1,000 gross pension contribution by a 40% taxpayer doubles in value and is then withdrawn wholly as pension income, it will be worth:

£1,000 x 2 x (100%-40%) = £1,200

A corresponding ISA contribution of £600 (i.e £1,000 gross less £400 tax) with the same value growth also produces £1,200:

£600 x 2 x 100% = £1,200

The Practice

- Tax rates may of course differ between entry and exit. If the tax rate is lower on the way out then the Pension would be favoured. However if tax rates are higher on the way out then the ISA would be favoured.

- National Insurance Contributions are ignored in the 'Theory' calculation. Employer contributions to pensions are NIC-free for both employer and employee. This is a major boost for the pension argument.

- Value  and contribution limits apply. For those doctors already above their life time allowance, pension contributions come with additional tax cost whereas there is currently no equivalent lifetime allowance for ISAs. On the other hand, ISA contributions are limited to £15,000 a year, whereas the annual allowance for pensions is £40,000.

- Pensions are subject to exit-timing constraints, which do not apply to ISAs. At present the normal minimum pension age is 55 (for personal pensions ofcourse - not the NHS scheme), rising to 57 in 2028 and perhaps 60 by early 2060's.

- The exit tax treatment for pensions is not a pure tax on the whole benefit. Usually 25% of the pension value is tax free with the rest being taxable. In most simple comparisons, this underlines the fact pensions should be put ahead of ISAs. The Tax Free Lump Sum is worth a 16.67% uplift on end value to 40% tax payers.

- There could be a lifetime allowance charge on part of the pension benefits on exit.

- Exit on death raises different tax issues. ISAs will generally no longer be tax free on withdrawal whist the pension will become tax free on death before 75. From age 75 onwards, the pension suffers tax at a higher rate of 45%. 

- Uncertainty of future Government legislation. Labour and Liberals have come out and said they would attack pension tax breaks. The Conservatives may come out in favour of cutting tax relief to a flat rate. Who knows?

Conclusion

Unfortunately, there does not exist a quick table of numbers to compare Pensions and ISAs. There are so many variables in practice that an examination of individual circumstances is needed. Diversification across different 'Tax Wrappers'  is recommended.

Get in touch on richard.higgs@wealthwestmedical.co.uk or 0117 966 5699.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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