Callum Hunter – Trainee Investment Manager
A common question for retail investors is, “How do I decide between adding funds to a pension or an ISA”. Although there is information available that starts to address this question, it tends to be qualitative in nature. This article seeks to provide some illustrative examples to explore this question to help the reader think about the mechanisms that underpin these products. Additionally, we will also mention a product that is often overlooked by online sources when it comes to thinking about this question.
A quick summary of ISAs and Defined Contribution Pensions
Under the ISA wrapper you can add up to £20,000pa (22/23 tax year) which can be invested into various securities. Any capital gains or income that arises from the investments held in an ISA are tax free when they are withdrawn by the individual.
By way of contrast, contributions to pensions receive tax relief on the way in, but are taxed as income when the funds are withdrawn. However, pensions do benefit from 25% of the total pot being tax free. Therefore, when funds are withdrawn from a pension, an adjustment is made such that only 75% of the withdrawal is taxable. So what does this difference look like over the long run?
An illustrative example
In order to build a model we need to first make various assumptions. For simplicity, English tax rates are used, monthly contributions are chosen such that at the age of 75, the value of the SIPP does not exceed the lifetime pension allowance, we assume no inflation and ignore any employer contributions made towards pensions. Therefore, we focus on the benefit of the return of the marginal rate of tax on pension contributions rather than employer benefits which can vary significantly from individual to individual. We also assume that annual growth is 5%, compounded on a monthly basis.
An individual has £250 to invest into either an ISA or a SIPP each month from the age of 25 to 65, after which, they will then retire and begin to draw on their savings. If invested into the SIPP, the individual can invest £312.50pcm due to the 20% basic rate of tax (£62.50) reclaimed by the SIPP provider on behalf of the individual. The plot of savings and growth is shown below.
From the graph above we can see that, prior to the individual turning 65, if they had contributed to a SIPP they would now have a pension pot worth £476,881.30, whereas, if they had contributed to an ISA, their savings would total £381,505.04 – a difference of approximately £95,000.
Now let us assume that in retirement, the individual wishes to withdraw £2,200 net each month. This can be withdrawn from the ISA with no penalties, however, when withdrawing from the SIPP, it is taxed as income. For simplicity we will assume that the individual already uses their Personal Allowance elsewhere, so all withdrawals (after adjusting for the tax free proportion) are taxed at the basic rate of tax (20%). Therefore, to receive £2,200pcm net from the SIPP, £2,588pcm needs to be withdrawn. This is plotted forward to the age of 82 (UK average life expectancy) below.
As can be seen in the graph above, after making monthly withdrawals from age 65 onwards, by age 82, the value of the SIPP is £279,286.37 while the ISA is valued at £181,473.12 – a difference of £97,813.25. It therefore can be concluded that, in this scenario, paying more money into a pension results more savings later in life due to the benefit of tax relief on the way in.
Of course, with so many variables factored into the model it is possible to create scenarios where an ISA leads to a larger sum by age 82. However, many of the assumptions that have been made already favour the ISA in modelling (such as ignoring employer contribution and pension contributions being made at the basic rate of tax). Given that the ISA is not overtly superior even with these assumptions having been made, it does imply that a pension will tend to be more advantageous to the majority of individuals from the sole perspective of wealth maximisation.
Best of both worlds?
The argument above shows that tax relief on the way in tends to outweigh the additional costs on withdrawal over the long run due to the power of compound growth, but what if there was a way of saving that receives relief on the way in and incurs no additional costs on the way out?
The Lifetime ISA (LISA) may be suitable for some individuals and meet this criteria. The advantage of the LISA is that funds paid into the wrapper benefit from a 25% boost from the Government up to a maximum annual contribution of £4,000pa. Therefore, after the Government’s contribution of up to £1,000, a maximum of £5,000 pa can be saved each year.
In the model above, the annual contribution of £250pcm equates to £3,000pa. Therefore, if this was paid into a LISA, the individual is effectively saving £3,750 (after the £750 bonus from the Government which is the same as the SIPP). Contributions can only be made to a LISA until the individual turns 50 and therefore, in the model below, £250pcm ISA (rather than LISA) contributions are made between the ages of 50 and retirement at 65 to allow for comparisons across scenarios.
Prior to the individuals 65th birthday, the LISA is valued £460,175.74 which is £16,705.56 less than the SIPP. However, as the £2,200 withdrawn from the LISA/ISA combination between the ages of 65 and 82 is tax free, the terminal value for the LISA/ISA is £365,975.59 (£86,689.22 more than the SIPP). This relationship is shown below.
Despite a larger terminal value, this does not necessarily mean that a LISA is “better” than a SIPP. If an individual is a higher rate tax payer, or if larger pension contributions are made this can drastically change the terminal value. Additionally, LISA funds will form part of an individual’s estate for inheritance tax purposes and this alone could offset any benefit an individual receives from this product. LISAs, like pensions, also have restrictions on when you can withdraw funds and penalties for early withdrawal, and therefore it would also be inappropriate to conclude that they are categorically “better” than an ISA. It will depend on individual requirements, but hopefully the above illustrations have provided some insight into the factors to consider when planning for retirement.
In summary, there is no clear cut “better” option in the ISA vs pension debate. There are far too many variables unique to individual circumstances which influence the decision (individual tax rates, age, flexibility, employer pension contributions, inheritance tax considerations and pension allowances to name only a few). In reality, most people will choose to use a mix of both to plan for their retirement, but it is important to ensure that you seek professional advice in order to find a balance across products that meet your individual circumstances as efficiently as possible. This article does not constitute investment advice, however, should you wish to explore these options further, Murray Asset Management would be delighted to help.