Trying to decide where to place your money is always a perplexing decision. Looking to the future and securing your wealth is important. But tying it up in a long-term pension can restrict the ability to use that money prior to the investment maturing.
When it comes to choosing between ISAs and pensions, the announcement that the Conservative Party plan to throw out the Death Tax is a pretty big game changer.
In some situations, pensions will become a much more attractive option, with the amount of potential taxation cut in half for the family of the deceased. So with this new Conservative proposal, what becomes the best option for your money?
Where The ISA Wins
If you want to have access to your money before you reach the age of retirement, then an ISA (NISA – New Individual Savings Account) is the best choice, as your money is not locked-in long term.
ISAs are also much simpler to manage and understand, making it much less hassle to keep track of your money.
If you are a basic-rate taxpayer, there is little difference in tax benefits between the two. As it stands now, if you have a basic tax rate, with an estate threshold below £325,000 (this is doubled for couples) your estate will not be charged inheritance tax.
Conversely, assets in a pension are currently taxed at 55%, unless you die before 75 with your pension untouched.
Where The Pension Wins
Following the proposed scrapping of ‘Death Tax‘, pensions become a more serious challenger to ISAs for those who want to bequeath their savings.
Experts also speculate that the government will replace the “death tax” by dropping higher-rate tax relief, replacing it with a flat rate of 30%.
It is therefore greatly dependent on your amount of wealth, with higher-rate tax payers facing greater charges through pensions if this is to be the case.
Prior to the Conservative’s proposed tax shake-up, top-rate tax payers who pay a lower rate in retirement, can receive a 40-45% tax relief when entering their money.
When it is withdrawn upon reaching the age of pension, they pay just 20% tax when taking money out, plus the tax free lump sum. This makes pensions a worthwhile investment for those with substantial wealth.
But What About Now?
When you compare this with the current circumstances for lower-rate tax payers, the only tax benefit of pensions over ISAs is the 25% tax-free lump sum available at the age of 55.
However, when you are contributing to your pension, the tax relief gained is cancelled out by the tax you pay on your pension’s income. Therefore the 25% tax-free lump sum is not that good a deal in the long run.
With the scrapping of the death tax, the advantage of pensions only arise when the individual wishes to leave some of their pension to their descendants.
The age at which you die can affect the options available to the descendants. If you die before 75, the 55% death tax will be scrapped entirely. All the money will be handed to your descendants, leaving them at will to spend it with no fear of taxation.
Death after the age of 75 means that whoever inherits the wealth can leave the money in the pension scheme and pay no tax. But any money withdrawn will be subject to taxation at the normal rate.
With this in mind, pensions may become something like a family ‘trust fund’ where the wealth is passed on, generation by generation, with the capital not being consumed but passed down, avoiding taxation. Yet each generation will still be able to take an income from the pension at any age.
With the current inheritance tax policies, this would be impossible to do.
In this circumstance, pensions greatly out-favour ISAs, as inheritance tax will be charged to each generation who receives the wealth, therefore greatly diminishing the funds available. Whereas with pensions, they exist outside the estate and therefore outside of the clutches of the death tax.
Aviva expert John Lawson calculated the advantages to be gained from pensions, following an individual who saved £500 a month between the age of 50 and 65, making a 5% return after taxation. If this was invested in an Isa, the individual would have saved £132,412 in an Isa.
Meanwhile, in a pension of a basic-rate tax payer, it would have accumulated £165,515 and with the tax-relief available to a higher rate tax payer, they would have a fund worth £220, 687.
When the amount of return is different, say for example a 3% after-tax income, pensions still have a clear advantage, with a higher rate taxpayer bequeathing funds amounting to £287,427, a lower rate taxation resulting in £215,570 accumulated at death, with an ISA only gaining funds worth £209,389.
In each circumstance, pensions come off better than ISAs, unless a higher rate taxpayer is not entitled to any tax cuts throughout.
When used carefully, an inherited pension fund can avoid even lower rate tax charges. Taking income when not working will avoid tax. Or perhaps the pension may form an emergency fund, aiding your circumstances when needed.
Inheritance Tax can be avoided completely if the wealth remains in the pension fund, or subject to normal rates if not. However, an Isa would form part of the estate, therefore subject to taxation unless the amount falls below the IHT threshold.
As a whole, it is important to assess your situation on an individual basis, accounting for wealth and debts when deciding between ISAs and pensions.
Deciding between ISAs and pensions is not a definitive decision; it is easy enough to switch between the two as long as you are mindful of the rules. Money taken from an ISA is tax-free but the amount paid directly into a pension cannot exceed your earnings in a tax year or the overall annual limit of £40,000, with the ability to carry forward three years of unused allowances.
Following these rules can increase your wealth when transferring from an ISA to a pension due to the tax relief available. If you do not earn enough income for the tax breaks, you can still pay £3,600 (gross) into your pension annually up until the age of 75.
As a whole, both options for savings can be beneficial to your wealth. Both will ultimately incur benefits. However, there are even occasions where neither an ISA or a pension is the right option.
For example, high-risk investments, where you may want to offset losses against gains from a number of options. For those who want to slowly and gradually accumulate their wealth, ISAs and pensions could be the way to go.