| Pension
or ISA: Which Investment Route Should You Take?
Copyright 2006 Ray Prince
Let’s look at a recent client we worked with, James,
a 45 year old dentist who had £500 per month to invest.
James was confident that he could invest this money
until his retirement at age 60, in 15 years time. He
has a mixture of PEPs and ISAs, with an NHS Pension
and a buy to let property.
Looking at this as one investment against another, we
need to look at a like on like projection. So we will
use a growth figure of 6% net of charges for both investments.
Because of the tax relief available for James at his
highest rate (40%), the amount he can invest into a
pension fund is £835 pm compared to the £500 pm to an
ISA. Using projections of the future fund values over
15 years we get figures of:
- Pension - £238,810 - ISA - £143,000
It appears there is no contest, however, let’s look
at the figures a little closer.
The ISA fund is all available as tax free cash, whereas
the Pension fund rules say a maximum of 25% of the fund
can be taken as tax free cash which is £59,702.
So if we calculate £143,000 minus £59,702 = £83,297,
this is the amount of tax free cash we have over and
above the Pension route. The remaining £179,107 in the
Pension fund has to be used to buy a pension called
an annuity. So the question now is what pension amounts
could be available for James?
Taking an average example and using today’s rates, a
level pension of £9,117 per annum would be achievable.
However, will James be a higher or lower rate tax payer
in retirement? This changes the picture somewhat, as
the following after tax pensions would be applicable:
- Higher rate tax payer - £5,470 per annum - Lower rate
tax payer - £7,111 per annum
So to compare this to the ISA, we need to see how many
years the pension needs to pay out to reach the £83,297
value of the ISA fund, allowing for growth on the ISA
fund at the same 6%, net of charges.
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The answer is 17 years for the basic
rate payer and 30 years for the higher rate payer! Not
only is this is a massive difference between the two,
but it also helps towards the decision whether to invest
into a pension tax wrapper or an ISA.
Other Considerations
-We have ignored any “pension drawdown” option
-The amounts you can contribute to pensions is currently
far more generous than that available to ISAs
-Annuity rates on pensions may improve or reduce in
the future
-The government may change the rules on either pensions
or ISAs or even abolish the tax favourability on one
or both
-Financial Advisers/Salespeople are often paid higher
initial commission on pensions than ISAs so make sure
your adviser is taking these factors into account, and
not just selling you a policy that pays him/her the
highest commission.
So what did we advise James to do?
In his case it all came down to the picture painted
by his cash flow model. This enabled us to see how James’s
wealth would look in the future.
What was clear was that his NHS Pension would in itself
take James into the higher rate tax bracket, and that
a tax free cash fund was more attractive to him than
more income that would be taxed at 40%. It would also
aid James to gift money to his 2 children, to both help
them financially and reduce his likely Inheritance Tax
liability.
Therefore, James invested monthly sums into an investment
Maxi ISA.
The Financial Tips Bottom Line:
In effect, there is no clear cut right or wrong. It
always comes back to balancing the pros and cons of
all the options available and making your decision based
on thorough research.
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