Basic rate taxpayers
Figures from Hargreaves Lansdown show that a basic rate taxpayer with a £15,000 investment in an Isa would have £34,725 after 25 years (assuming 6% growth a year) but if that money had enjoyed upfront tax relief in a pension it would have been worth £43,406.
However when you come to take cash from your pension, anything after the first 25% will be liable to income tax. For somebody paying 20% tax this would bring their pension's value down to £36,895 and £30,384 for a higher rate taxpayer if they were to cash the whole pot in.
So basic rate taxpayers seeking to make large cash withdrawals (enough to bring themselves up a tax bracket) could be better off saving with an Isa. That said, if they were to take the cash out gradually - to prevent them being dragged into a higher tax bracket – the overall tax they pay would be reduced.
Higher rate taxpayers
But while pensions will typically be better for those who pay the basic rate of tax while working, pensions are streets ahead of Isas for those workers who pay the higher rate of tax and get 40% tax relief on their pension contributions.
A 40% taxpayer, paying £15,000 into an Isa would still get £34,725 after 25 years, but thanks to that higher tax relief on contributions they'd end up with a £57,875 in a pension. Of course they would be liable to income tax when they cashed it in, but an investor who cashed in the fund in one go and became an additional rate tax payer in that year (which from a tax point of view would not be very sensible) would still end up with £38,342.
So while the combination of tax efficiency and flexibility make Isas a great way of saving for medium-term goals such as a loft conversion or university fees, most people will end up with a bigger retirement pot if they save for it in a pension. This is especially so if you are in a workplace pension and your employer makes contributions on your behalf.
"Pensions win the pure numbers game, which isn't surprising given the head start they get from up-front tax relief, and the fact 25% can be drawn as tax-free cash. The exception is basic rate taxpayers who draw their whole pension as a lump sum, and so end up paying 40%, or even 45%, tax."
While these savers could potentially land themselves with a big tax bill, that liability could be reduced substantially by leaving the fund in the tax-sheltering pension and only taking money for income as and when it is needed.
"People need to think about the tax efficiency of pensions versus the flexibility of Isas. Retirement savings should predominantly be in pensions but once they start being cashed in they can think about recycling that money back into Isas in retirement."
As always if you would welcome some Independent Financial Planning Advice, then at Investment Solutions we are here to help!