Craig Muir: Could you use a pension to offset ISA losses?

Craig Muir runs through an ISA/pension case study which focuses on offsetting potential losses clients may have suffered in recent weeks...

We live in unprecedented times, as I write this President Trump is suggesting UV light and disinfectant to kill Covid 19…

Investment markets have fallen, workers have been furloughed and many are worrying about the investment performance of their ISAs and pensions. Here’s one suggestion for how you can boost clients’ assets.

We’re going to consider a client who has money in an ISA and how they can increase their assets by switching it to their pension. I’m going to use a case study to demonstrate this.

Case study

In April 2019, Graham was aged 55, employed with a pension fund of £400,000 and was a higher rate taxpayer. At this time he put £20,000 into a balanced portfolio with his ISA provider.

By April 2020 his ISA portfolio had dropped 20% from the original value and was valued at £16,000. Graham recognises portfolio values can fluctuate but is concerned he needs 25% growth to recover his loss.

Over the next five years his balanced portfolio performs well and returns 31.25% bringing Graham’s fund up to £21,000. However, based on his initial investment of £20,000 this is a compound annualised return (CAR) of just 0.82%.

So what could Graham have done differently?

Graham understands how pension tax relief works and knows that regardless if you’re a non-taxpayer, basic, higher or additional rate taxpayer, if you pay into a relief at source personal pension scheme, the pension provider will provide basic rate tax relief.  If you’re a higher or additional rate taxpayer then you can claim the extra amount of tax relief back from HMRC.

So although the ISA value had dropped to £16,000 in April 2020, if Graham had switched it to his pension this would have attracted 20% tax relief.

Graham has enough annual allowance to make this contribution.

As Graham is a higher rate taxpayer, he knows he can claim the additional tax relief from HMRC but decides he would rather boost his pension pot.

He works out that a gross contribution of £26,667 would produce a net contribution of £16,000 after 40% tax. As the pension provider only applies basic rate tax relief at 20%, Graham realises he would need to pay a net contribution of £21,333 for a gross pension amount of £26,667.

If Graham had an additional £5,333 on deposit and he paid this in at the same time as the £16,000 from his ISA, his gross pension contribution would have increased to £26,667.

As a higher rate taxpayer, Graham would claim the £5,333 back from HMRC to replace the money he had on deposit.

So instead of having £16,000 in his ISA, he has £26,667 in his pension.  This is an increase from his initial investment of 33% and 67% higher than what he would have had in his ISA.

Assuming the charges are the same and Graham invests in a similar balanced portfolio and receives 31.25% return over the next 5 years, his pension would be worth £35,000, an annualised growth rate of 9.78% of the initial ISA investment, compared to 0.82% in the ISA.

Great, but the ISA would provide £21,000 tax-free and of course the pension will be taxed at Graham’s marginal rate so what would the net income be?

Perhaps at age 61, Graham will be a basic rate taxpayer but even if he’s still a higher rate taxpayer then he would receive £24,500 net instead of £21,000 from his ISA.

Other factors to consider

As an adviser, you would also need to consider many other factors before taking the decision to stay in the ISA or move into the pension.

For example, the impact of the money purchase annual allowance if Graham took his pension pot as a lump sum. Death benefits should also be taken into account. If Graham was to die at age 61 and his estate is in excess of the nil rate band for inheritance tax (IHT) then his £21,000 ISA would be subject to 40% IHT. This compares to the personal pension pot of £35,000 that would be paid tax-free to his beneficiaries.

Of course, you will need to consider your client’s personal circumstances and objectives and a combination of tax wrappers will likely provide the most tax-efficient income in retirement.

However, the tax relief granted to pension contributions could help to alleviate some of the losses from other investments. We can’t change past performance but using a different tax wrapper could improve the chance of better performance in the future.

Craig Muir is senior intermediary development & technical manager at Royal London