Copyright 2006 Ray Prince
Let’s look at a recent client we worked with, James, a 45 year old dentist who had £500 per month to invest.
James was confident that he could invest this money until his retirement at age 60, in 15 years time. He has a mixture of PEPs and ISAs, with an NHS Pension and a buy to let property.
Looking at this as one investment against another, we need to look at a like on like projection. So we will use a growth figure of 6% net of charges for both investments.
Because of the tax relief available for James at his highest rate (40%), the amount he can invest into a pension fund is £835 pm compared to the £500 pm to an ISA. Using projections of the future fund values over 15 years we get figures of:
- Pension - £238,810 - ISA - £143,000
It appears there is no contest, however, let’s look at the figures a little closer.
The ISA fund is all available as tax free cash, whereas the Pension fund rules say a maximum of 25% of the fund can be taken as tax free cash which is £59,702.
So if we calculate £143,000 minus £59,702 = £83,297, this is the amount of tax free cash we have over and above the Pension route. The remaining £179,107 in the Pension fund has to be used to buy a pension called an annuity. So the question now is what pension amounts could be available for James?
Taking an average example and using today’s rates, a level pension of £9,117 per annum would be achievable. However, will James be a higher or lower rate tax payer in retirement? This changes the picture somewhat, as the following after tax pensions would be applicable:
- Higher rate tax payer - £5,470 per annum - Lower rate tax payer - £7,111 per annum
So to compare this to the ISA, we need to see how many years the pension needs to pay out to reach the £83,297 value of the ISA fund, allowing for growth on the ISA fund at the same 6%, net of charges.
The answer is 17 years for the basic rate payer and 30 years for the higher rate payer! Not only is this is a massive difference between the two, but it also helps towards the decision whether to invest into a pension tax wrapper or an ISA.
Other Considerations
-We have ignored any “pension drawdown” option
-The amounts you can contribute to pensions is currently far more generous than that available to ISAs
-Annuity rates on pensions may improve or reduce in the future
-The government may change the rules on either pensions or ISAs or even abolish the tax favourability on one or both
-Financial Advisers/Salespeople are often paid higher initial commission on pensions than ISAs so make sure your adviser is taking these factors into account, and not just selling you a policy that pays him/her the highest commission.
So what did we advise James to do?
In his case it all came down to the picture painted by his cash flow model. This enabled us to see how James’s wealth would look in the future.
What was clear was that his NHS Pension would in itself take James into the higher rate tax bracket, and that a tax free cash fund was more attractive to him than more income that would be taxed at 40%. It would also aid James to gift money to his 2 children, to both help them financially and reduce his likely Inheritance Tax liability.
Therefore, James invested monthly sums into an investment Maxi ISA.
The Financial Tips Bottom Line:
In effect, there is no clear cut right or wrong. It always comes back to balancing the pros and cons of all the options available and making your decision based on thorough research.
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Ray Prince is an Independent Financial Planner with Rutherford Wilkinson plc, and helps UK Resident Doctors and Dentists get the best deals on mortgages, protection and investments, as well as helping them achieve their financial objectives. Just visit www.medicaldentalfs.com to get your free retirement guide. Rutherford Wilkinson plc is authorised and regulated by the Financial Services Authority.
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