Welcome to the March 2019 newsletter from Chamberlains
The tax year end is fast approaching and, as I mentioned in the February newsletter, there are a number of things to think about before 5 April – allowances that are lost if you don’t use them each tax year. Most of us can’t afford to use all of them, but it’s good if you can benefit from at least some.
If you have spare funds, one particular decision is whether to put money into a pension or an ISA. Basically, a pension contribution is generally more tax efficient (especially for people paying tax at more than the basic rate of 20%), but ISAs are more flexible and have their own advantages.
Let’s look at the pros and cons and differences by some FAQs for a change (referring to standard ISAs and Personal pensions)…
1. If I’ve got £10,000 spare (chance would be a fine thing, you may think!), how does it affect my tax now if I pay it to one or the other?
ISA – no effect.
Pension – If you’re a 40% or 45% taxpayer, you can claim a tax refund on your next tax return. The government will immediately put another £2,500 into your pension pot, and you gain at least another £2,500 via your tax return. (Technically, your basic rate band is extended by £10,000, so that you pay tax at 20% on more of your income, rather than higher rates.) So the £12,500 in your pension pot will have cost only £7,500 if you’re a 40% taxpayer.
2. What happens to it once it’s in the ISA or the Pension pot?
Same for both – any income or growth in value is tax-free. Neither need to appear on your tax return. You can move it from one investment to another within the ISA wrapper or the pension pot.
3. What can I invest in?
ISA – Cash, Investment (stocks and shares – either directly in specific companies, or in investment funds), Innovative finance (peer-to-peer lending – high rates of interest, but higher risk)
Pension – Same as ISAs: Cash and Investments, but not Innovative finance.
In both ISAs and pensions, you can move between cash and investments quite easily.
4. How do I get it out again when I want to use the money?
ISA – You contact the ISA-provider and tell them that you want to cash it in. The money appears in your bank account and you go off to buy your Lamborghini.
Pension – You can’t get at it until you’re 55 years old (except with draconian tax-penalties.) You can then take 25% tax-free. The rest is treated as taxable income when you take it. If you take everything in one go, you may well find that you’re paying tax at higher rates, but if you take it out gradually you may well just pay basic rate tax.
There are two main ways of taking the pension over a longer period – a) you buy an annuity, so that you have assured income for the rest of your life, or b) you arrange for your pension provider to sell some of the investments and pay you the cash as you need it. The second route means that you’re eating into the capital, but the remaining capital is still growing.
5. How does the tax work with this?
ISA – completely tax-free.
Pension – the income is taxable when you take it. The ideal situation is that you pay money into the pension when you’re earning enough to pay tax at higher rates (so that you benefit from the extra tax refund via your tax return) but take it out when your income is low enough to just pay tax at the basic rate of 20%.
6. How about some figures?
OK, let’s assume that you invest £10,000 and that you get 5% annual growth in both ISA and Pension for 10 years, after which you cash it in. You’re a 40% taxpayer now, but when you retire in 10 years you have sufficient spare basic rate band to pay 25% tax on your pension.
ISA – over 10 years, this grows to £16,289 You get this tax-free.
Pension – you immediately reinvest the higher rate tax refunds, and it’s a cumulative series of refunds, so that you end up with £16,666 in the pot. After 10 years, this has increased to £27,148, but you need to pay tax on 75% of this (you’ll remember that 25% is tax free) so the net amount you receive is £23,075. Considerably better that the ISA! Let me know if you’d like to see my calculations…
NB – if you start as a basic taxpayer, you don’t get the higher-rate benefits on the initial contribution, so the difference is much smaller – you only get £17,307 net of tax when you take the pension. That’s over £1,000 better than the ISA, but you might prefer the easier accessibility of the latter.
7. Can I switch from one to the other?
ISA to pension – Easy. Cash in the ISA and pay it into a pension to get the immediate tax advantages
Pension to ISA – If you’re over 55, you can take out the tax-free 25% and put it into an ISA, up to the annual ISA allowance. And after the 25%, you can take any other income from the pension and invest it in ISAs if you don’t need the income for day-to-day living.
8. What’s the Annual Allowance? How much can I put in each year?
ISA – £20,000. There’s no way to use unused allowances from previous years.
Pension – up to the lower of your relevant income or £40,000. If you didn’t use the full £40,000 in the previous 3 years, you may be able to do so now, but only up to your relevant income. If your relevant income is over £150,000, the £40,000 reduces – tapering off to £10,000 if your income reaches £210,000.
9. What do they mean by “relevant income”?
ISA – it doesn’t matter – you can put in the full £20,000, no matter what income you might have.
Pension – Basically, it’s your earned income, rather than investment income. Dividends don’t count, nor do pensions. In fact it’s a bit more complicated, including:
• Salary plus taxable benefits
• Self-employed income
• Redundancy over the tax-free £30,000
• Profit on furnished holiday lettings (these count as a trade)
• Statutory Sick Pay (SSP) and Statutory Maternity Pay (SMP)
• Patent income
10. What happens if I die?
ISA – it’s part of your estate and subject to Inheritance Tax (IHT) like any other of your assets. If your spouse inherits it, there’s no IHT, just like the rest of what you pass to them. It can also stay as an ISA. (This is new, as from 2015 – previously the ISA wrapper vanished, and income from the investment or cash became taxable.)
Pension – it depends on your age and on what you’d been doing with the fund. If you’d bought an annuity with it, it depends on the terms of the annuity. For example, some people arrange for the surviving spouse to get 50% of what you were getting; some arrange for the full amount to continue, etc.
If you’ve taken no income from the pension fund, the full value will go to your dependants. If you die before the age of 75, this will be non-taxable for them, even if you’d started to take an income. If you’re 75 or over, they’ll pay tax on what they receive. The rules are a bit complicated, but basically the pension is subject to income tax rather than inheritance tax. Some people think it’s a good form of IHT planning – but that’s perhaps something for another newsletter.
IN SUMMARY, although ISAs are more flexible and the money is more accessible than in a pension, pensions are much more effective savings vehicles, longer-term, thanks to the great head-start they get from the government. (See point 6 above) If you have the opportunity to put some money into either, you can beat the deadline by investing cash, and you can decide what investment funds etc. to use later.