As is clearly demonstrated by this simple example for a higher rate taxpayer, the difference in return of almost £100,000 between money saved in an Isa to that saved in a pension, may make them more likely to consider the benefit of contributing to a pension.
So what happens when the individual retires? Taking income from an Isa is tax free, however pension income is taxable, although figures from HM Revenue and Customs (HMRC) indicate that six out of seven individuals who were higher rate taxpayers during their working lives will be basic rate taxpayers in retirement.
Looking at the example in a bit more detail and presuming on retirement the individual took 25 per cent of their Isa fund and the 25 per cent tax-free pension commencement lump sum to pay off debts and then took a net income of £7,200 pa (£9,000 pa gross from pension), increasing by 3 per cent pa from the remaining funds, we see in Chart 1 and Chart 2 that after 18 years the individual has received just short of £161,000 net income from both the Isa and personal pension. However, the Isa fund is almost exhausted with only £6,689 left, while the pension fund has over £120,000 remaining. This could be used to continue to provide a drawdown pension or buy an annuity, if appropriate.
An alternative scenario is if the individual had died after 18 years, and assuming their estate was liable to inheritance tax at the rate of 40 per cent, then £4,013 would pass to their beneficiaries from the Isa. The remaining pension fund, although not subject to inheritance tax, would be subject to the special lump sum death benefit charge at the rate of 55 per cent leaving £54,144 to pass to their beneficiaries.
A summary of the overall position is shown in Table 2.
Even after income tax on pension income, and the lump sum death benefit charge on the remaining pension fund, the individual and his beneficiaries will have benefited from around £75,000 more from the pension than the Isa.
It has to be emphasised that this is only one example. How best to save for retirement and, of even more importance, how income is taken throughout retirement is a complex issue. It should not be assumed that taking the maximum income from your pension is the best option; more than likely it may come from blending income from a combination of pension, Isa and other investments. What this example does illustrate though, is that the ability to defer any taxes until retirement is a benefit not to be ignored.
Neil MacGillivray, head of technical support unit, James Hay Partnership
