Retirement wrappers: Do pensions still trump ISAs?

Speaking at the second Retirement Planner breakfast briefing, in association with Prudential, head of technical Les Cameron gave advisers in the room his take on the ISA v pension debate in light of pensions freedom

The Budget has brought massive changes. But these are massive changes for saving, not massive changes for retirement income.

Freedom has always been with us, it used to be £12 was a triviality limit. Over 30 years ago, people with small pensions did have total access to them.

It’s only recently, with flexible drawdown, people with lots of money had total access to their pension funds.  What the Budget has done is give all the people in the middle, who have never had total access, total access now.

Before, they were restricted by annuity rates, or Government Actuary’s Department (GAD) rates, or whatever, they couldn’t get their hands on the total pot. But everybody can now get their hands on the total pot, and I think that’s a good message for saving. The budget was about stimulating saving, not a message for getting it back out again.

Tax doesn’t have to be taxing

Now, this is where I get a bit ‘tax-y’.  We’ve got a pensions tax wrapper in the UK. It’s commonly known as ‘exempt, exempt, taxed (EET)’, which means, basically, tax relief on the way in, no tax during, and then you get taxed on the way out.

You do get a quarter of it tax-free on the way out, so it’s not totally taxed. It could, potentially, be totally exempt on the way out, if you keep it within the personal allowance, that’s probably going to be unrealistic. But EET is probably the best tax position available for a wrapper in the UK. The other end of that is the ISA. So you’ve got pension with EET but an ISA has no tax relief.

An ISA is “taxed” at the outset, but then it’s exempt and totally exempt on the way out or TEE.

So, the ISA versus pensions debate: which one are you picking? I think it’s a tax call; it’s not an investment call, most investments are available in most wrappers.

There are other wrappers available. You’ve got OEICs, bonds, onshore and offshore.  These are all taxed at entry; you will have saved up from tax income.

It’s potential for them to be exempt during, depending on your customer.  A basic rate taxpayer holding OEICs won’t pay anything during and taxed on exit  if you cashed in over your annual CGT allowance.

But basically, the best you can get with OEIC, and onshore and offshore, is maybe taxed, exempt, exempt based on circumstances.

Money machines

That’s the tax story, but the tax story is largely irrelevant, because tax wrappers are just money machines.

You put money in one side of them, you churn it about for a while, and then you get some more money out the other side.

You can talk about higher rate thresholds, tax bands, etc, etc, but what should really matter to a client is; what am I giving up?  What do I get back? And how long do I have to wait for it?  Because that’s all that really matters.

So you’ve got a choice. Do you do pension or do you do ISAs, when you’re saving up for retirement?  It’s an age old debate, but 20 minutes after the Chancellor’s budget last year we concluded that debate had been settled.  At least until they change the rules again.

It’s always been about access.  With an ISA, you always have total freedom. Get your money any time you like.

Pensions, you couldn’t get them prior to 55, obviously, but even post-55, there was still a bit of a constraint. Because unless you were super rich, you were going to be constricted by a GAD limit or an annuity rate, so you weren’t getting total access to your capital.

But what George, God love him, did, is give total access to everybody beyond 55, and that’s the fundamental thing that’s changed the debate.

If you’re saving for a post-55 event, whether it’s income or capital, both tax wrappers now have total access. So it’s how do I save up the maximum amount of money?  What tax wrapper am I going to use?

I think the pension wrapper’s looking so good: is the pension going to become your primary retirement tax wrapper?  And then you’ll have your non-pension wrappers, possibly for other needs.  You might need access to a lump sum tax-free.

If you’re doing tax planning, you don’t want an emergency need to come along that pushes you into taxed income that you otherwise wouldn’t have had.

Heart of the matter

So it might be a case of having lots of different wrappers available with a pension at the heart of it.

Under current rules you can get over £40,000 without writing any cheques for the revenue.  You can get £40,000 without tax, under the current system.

Using the personal allowance of £10,600 and the savings rate band, recently increased to £5,000 gives you £15,600 of potentially tax-free money.

You’ve got your basic rate band, then your higher rate band. If you’ve got multiple pots, it could look something like this.

Pension, any income within the personal allowance would be tax free. Possibly offshore bond gains, less than £5,000, they would sit in the savings rate band. So chargeable event, but no tax to pay, all tax-free. Equty income from shares or equity OEICs that is wholly within the basic rate tax ban are tax free due to the dividend tax credit.

So apart from capital gains tax, if you make a big enough gain, equity OEICs and unit trusts are, essentially, tax-free wrappers for basic rate taxpayers.

So if you know your equity income’s going to be sitting in the basic rate tax band, that could put you up to nearly £40,000 without having to write any cheques to
the revenue.

And then your higher rate plus, you’ve got your 5% tax deferreds from onshore bonds, use your ISA income, just use pension commencement lump sum only from your pensions.

If you plan it with multiple pots, you can get a significant amount of tax free money in retirement.   So, what’s the best retirement wrapper. There is no correct answer. I think financial planning has many different moving parts. Some of them are more important than others. Some parts will be bigger than others some years than other years.

Some years, you’ll be in a different tax status than you otherwise would be. Some years, inflation will be high. So it’s maybe a case of getting the right selection of wrappers to suit the client’s individual circumstances.

But to conclude, wrapping up retirement wrappers, a pension will make your budget go further, you will generate a higher net income.

If you have a target in mind, a pension will get you your target cheaper, purely through tax relief.

If pensions and all other wrappers are on the table, and you can only afford one wrapper, the pension wrapper wins.