Pensions and Individual Savings Accounts (ISAs) – are they worthwhile?

There is a debate in the UK about whether pensions are better than ISAs, which has been running for many years, perhaps even for a generation.

Investing in either an ISA or Pension gives great tax advantages, saving investors substantial sums of money during their lifetime. Both have advantages and disadvantages but what it really comes down to is tax vs. access to capital.

‎Broadly speaking, do you want your tax advantage now (pension) and if so, are you comfortable in giving up access to your money until you are 55? Or would you prefer the greater flexibility provided by ISAs?

‎If you are internationally fluid (defined as such if you move country of residence every couple of years) then you may prefer to simply save without the constraints of any tax-efficient wrapper, and don't bother with the case study below unless you are curious.

‎Pensions:

Ultimate tax savings wrapper but "lockdown" until age 55

Pension contributions are tax incentivised; that means the UK government incentivises individuals to save for their retirement by providing tax relief on contributions that the individual makes to a qualifying pension plan. The tax relief is mostly given at the individuals marginal income tax rate although there are some restrictions on the amount of tax relief for high earners (those earning more than £240,000 p/a). The UK government also incentivises contributions made by your employer into a pension on your behalf. In addition, income received in your pension is not taxed during the accumulation and neither are capital gains; the returns accumulate without tax.

ISAs:

Balancing between tax saving and flexibility but with a cap

ISAs are tax incentivised but in a different way. There is no tax relief on contributions; you can annually contribute your after-tax income into an ISA, currently capped at £20,000 p/a. As with pensions, returns accumulate without tax.

Quick comparison between the two tax wrappers:‎

Consider the example of George, who is aged 40 years old. He is a 40% taxpayer, earning £150,000 p/a. If he bought an ETF for £20,000, received dividends of £4,000 (£2,000 of which are tax-exempt) and then sold the ETF for £40,000, then he would pay tax on the dividends at 32.5% (dividend rate) losing £650 to tax.

Furthermore, assuming he used his annual capital gains tax exemption elsewhere, then he would pay tax at 20% on the gains of £20,000 losing a further £4,000. If the ETF were held in an ISA or a pension, then that's a £4,650 tax amount he would save.

It's important to mention that George would have different numbers if he was a Scottish taxpayer (since Scotland has different tax rates). For brevity, we are not going to go into detail on the differences here, but in the appendix, you can get further information.

‎The international element

If you are only in the UK for a few years, then it is questionable as to whether an ISA makes much sense. You have the option to invest outside the UK and to claim the remittance basis if you have Resident Non-Domiciled (RND) status, meaning you will not normally pay tax on your non-UK income and gains anyway. In any case, ISAs only have tax-free status in the UK and therefore if you leave the UK and go somewhere else the income and gains could become taxable in your next destination country.

True, ISAs are only tax exempt under UK tax and therefore if you have relocated to another country, the UK exemptions from income and capital gains tax will no longer apply. However, you could take the view that the UK tax exemptions coupled with the general simplicity of the ISA scheme are worth having whilst you are UK resident and then simply dispose of your ISAs before you leave the UK and become tax resident in another country.

Pensions may be more valuable but remember you cannot access the underlying capital until you are 55 under UK rules and you may feel this is too long to wait.

If you have come to the UK on an International secondment, then you will likely remain part of your employer's global pension scheme and benefit accordingly. If you personally contribute to a UK pension plan whilst being UK resident, then you will have accumulated a pot of money with UK tax relief. When you leave the UK, you might be able to transfer to a pension scheme in your new country of residence if this is a qualifying recognised pension plan (QROP). This subject is quite complicated and will be the subject of a future article.

So how do the figures work?

How about a "combination approach" for the maximum benefit:

Let's continue with the example of George: he is trying to decide whether to pay £20,000 into his self-invested pension plan (SIPP) or into a Stocks and Shares ISA.

‎He is a 40% taxpayer, earning £150,000 p/a. If George contributes the £20,000 to his SIPP then this will be grossed up for 20% tax to £25,000. George will receive further tax relief at 20% (40-20%) on £20,000 meaning he now has a further £5,000 to invest in an ISA. That means he has £30,000 working for him from day one for a £20,000 pension contribution rather than £20,000 in an ISA.‎

Assuming George draws down on the pension or ISA at age 60, and assuming a compound growth rate of 7% in the interim 20 years net of charges then George will have accumulated approximately £77,394 in his ISA vs. approximately £116,090 in the SIPP/ISA combination.

In other words, for the same net contribution of £20,000, George ends up with approximately £38,696 more in the SIPP/ISA combination.

When does the ISA win? 

It's all about access - can I get to my money? If George above had wanted access to his money at age 50 then the SIPP would be no good as he cannot access that until he is 55.

‎Furthermore, although the SIPP/ISA combination produces nearly 50% more over 20 years for the same initial contribution only 25% of the SIPP can be drawn tax free. The remainder is taxable as income in the tax year it is drawn i.e. up to 45% for an additional rate taxpayer. The ISA can be drawn completely tax free.‎

Using the example of George above, the table below examines the amounts net of tax on 75% of the SIPP at various tax rates. As you can see although the SIPP still wins, the net of tax returns are much closer especially at an assumed 45% tax rate. 

‎The following table is a high-level view of the comparisons between the SIPP / ISA combination and an ISA.‎ Appendix: The Scottish example

HMRC provide the following comparison:

‎Claim tax relief in England, Wales or Northern Ireland‎

You can claim the additional tax relief on your Self-Assessment tax return for money you put into a private pension of:

20% up to the amount of any income you have paid 40% tax on

25% up to the amount of any income you have paid 45% tax on

Claim tax relief in Scotland

You can claim additional tax relief on your Self-Assessment tax return for money you put into a private pension of:‎

1% up to the amount of any income you have paid 21% tax on

21% up to the amount of any income you have paid 41% tax on

26% up to the amount of any income you have paid 46% tax on

Please note that this is not a financial advice and it does not take into account individual circumstances. Please also contact a professional advisor prior to any decision making.

Tax benefits may vary as a result of statutory charges and their value will depend on individual circumstances. Specific risks associated with particular investments are detailed on this website and in our printed literature. You should consult with a professional tax advisor for any tax advice and support.

The value of an investment and the income from it can go down as well as up and investors may not get back the amount invested. This may be partly the result of exchange rate fluctuations in investments which have an exposure to foreign currencies. You should be aware that past performance is no guarantee of future performance.