On the 6th April 2015, we will see the introduction of the new rules governing pensions and the flexibility that clients may enjoy in their taking benefits in their retirement.
For those already utilising pensions, these new rules have greatly improved what was already considered an attractive investment opportunity. For those that were adverse to the concept of using pensions in their retirement planning, this significant change has seriously turned heads. No longer does one have to weigh up the advantages of pensions against the previous downside of what some may consider quite rigorous restrictions on what you can withdraw from the plan. Clearly that is not to say that there are not considerations, but when compared against the saver’s favourite that are Individual Savings Accounts (ISAs), we believe the new rules now give investors pause for thought over which of their allowances they should use first. In simple terms, as a result of the imminent rules changes, are pensions the new ISAs?
Firstly let us take a look at ISAs. In simple terms, an investment is made, upon which no tax relief is granted at outset, the investment rolls up predominantly tax free (save for the non-reclaimable tax credit on dividends) and at the point that the investor requires access, no tax is payable on income / withdrawals made or on the gains hopefully enjoyed.
Pensions on the other hand, they receive Income Tax relief at the prevailing rate at the point the personal investment is made. Like ISAs they roll up predominantly tax free (again save for the non-reclaimable tax credit) and at the point that benefits are taken, 25% is tax free with the remainder subject to Income Tax at the client’s marginal rate.
So both offer the same tax efficient investment environment with regard to the underlying funds and neither will no longer restrict the investor regarding how they access the funds. Admittedly there remains the fact that investors may not gain access to their funds until they reach the minimum age of 55. However, for those close to or already 55, this will not be an issue.
So the key difference seems to lie with the differing tax treatments on the way in and way out and it is this which may now result in the pensions becoming the first choice with some investors. Let us look at an example.
Jeff is 55 and is employed and is presently a basic rate tax payer and anticipates being so in retirement. He has previously diligently utilised his annual ISA allowance and is about to consider doing so again prior to the end of the 2014 / 2015 tax year, investing the full £15,000. The ABC UK Equity fund returns 50% net of charges over 5 years and at the end his investment is worth £22,500.
His friend, Steve, also 55 and a basic rate taxpayer, having heard of the new rules decides to consider investing £15,000 into a pension. With the benefit of Income Tax relief this grosses up to £18,750. Again the ABC UK Equity fund yields a net return of 50% over 5 years, and so at age 60 is worth £28,125. Under pension rules, he is entitled to take 25% of this as tax free cash, equating to £7,031.25, with the remainder, whether taken as an income or lump sum, subject to marginal rate Income Tax. He decides to crystallise this as a lump sum and as a basic rate taxpayer in retirement, the remaining £21,093.75 reduces to £16,875. Coupled with the tax free cash payment of £7,031.25, this provides a net return of £23,906.25.
By investing into a pension rather than an ISA, this increases the net return by £1,406.25, an increase of 6.25%.
Two further friends, Bob & John, are higher rate tax payers and will continue to be in retirement. They too are considering £15,000 investments. Bob follows Jeff’s path of investing into an ISA whilst John, like Steve, invests into a pension.
Bob’s £15,000, vested into the ever popular ABC UK Equity fund, provides a net return of £22,500.
John receives 40% Income Tax relief so from a £15,000 net investment, his gross contribution is £25,000. In 5 years, via the ABC UK Equity fund, this is worth £37,500. His 25% tax free cash is £9,375 and the remaining £28,125 nets down to £16,875 after 40% tax. This results in a total net return of £26,250.
By investing into a pension rather than an ISA, this increases the net return by £3,750, an increase of 16.7%.
These examples alone are quite compelling. However, the proposed change to the treatment of pensions on death may further enhance the appeal of pensions, particularly for those with possible Inheritance Tax (IHT) liabilities.
ISAs, whilst tax efficient during an investor’s lifetime, upon death will form part of one’s estate. Where IHT is payable, 40% tax will be due.
Pension funds will continue to remain outside of an investor’s estate for IHT purposes. Where death of the investor occurs pre age 75, lump sum and income benefits will be tax free in the hands of beneficiaries. Where death occurs post age 75, lump sum benefits (post 6th April 2016) and income will be subject to their marginal rate of tax as and when taken. For basic rate taxpayers this will be at a lower rate of 20%, and for higher rate taxpayers, this will be no worse than IHT at 40%. However, those that are higher rate tax payers may simply defer any benefits until a lower rate can prevail.
Clearly the examples are quite simple ones and every client circumstance is different. However, we would suggest these are compelling reasons to at least give consideration to pensions. Not only could they be advantageous for new investments hereon in, one may perhaps wish to consider transferring existing ISA funds, into pensions.
Please feel free to contact us is you wish to discuss this opportunity and how it can fit into your own financial planning arrangements.