Tax relief upfront is the same as tax relief later: Pensions versus ISAs

There is nothing magical about pensions versus ISAs, the UK’s two tax-free savings wrappers, that enables pensions to break the laws of mathematics.

Both pensions and ISAs deliver one-shot tax relief, as well as allowing your savings to grow tax-free.

• Pensions give you the relief upfront, by rebating the tax you’d otherwise pay on your contributions.

• ISAs give you the tax break later, since you pay no tax when you cash in your ISA investments.

You’ll often hear people claim that pensions are better than ISAs because upfront relief is more valuable. “You have more money to compound over the years with a pension,” they say, which they claim gives pensions the edge.

But this is wrong – all things being equal.

Now, all things are rarely equal, and I’ll get to that in a minute.

But first the science bit.

Pension versus ISAs: A quick recap

Pensions

• With a pension, you get tax relief on your contributions.
• If you pay 40% tax, say, then a £1,000 contribution costs just £600 of taxed income.
• You pay tax on the money you take out when you retire.

ISAs

• With an ISA, you get no initial tax relief.
• Instead, you put some of your taxed salary into the ISA.
• However, you do not have to pay tax on the money you withdraw later.

Mathematically speaking, there is no difference between these two situations, provided the tax rate is the same.

Proof that ISAs and pensions are the same, maths wise

Here’s some algebra to prove pensions and ISAs are equivalent – all things being equal.

Consider the variables:

• A lump sum investment of £x
  Tax rate of t%
  Annual growth of i%
  Investment period n years

With an ISA you get no initial tax relief, and you pay no tax on withdrawal.

The formula for how your money compounds over ‘n’ years is therefore simply:

• ISA = x * (1+i)^n

With a pension you get tax relief of t%, but you also pay t% tax when you withdraw the money later.

The formula for how your money compounds over ‘n’ years is:

• Pension = x/(1-t) * (1+i)^n * (1-t)

Now, (l-t)/(l-t) cancels out. This leaves us with:

= x * (1+i)^n

Which is exactly the same as the ISA!

This is why some prefer to use the phrase ‘tax deferment’ rather than ‘tax relief’ when talking about pensions. The relief you get upfront is cancelled by the tax you pay later – all things being equal.

A worked example of tax equivalence

Here’s an example of pensions versus ISAs with real numbers.

Consider a higher-rate taxpayer who:

• Sets aside £1,000 of his gross salary to invest every year
  Pays 40% tax
  Gets 10% a year growth on his investment
  Leaves it to compound for five years
  Draws an income of 5% a year in retirement

With the ISA, he is funding his contributions out of his taxed income.

Higher-rate tax is 40%, so our man’s £1,000 contribution is multiplied by (1-0.4=0.6) to reduce it by 40%, then compounded over 5 years, and then finally, he takes out 5% (so we multiply by 0.05).

• £1,000×0.6×1.1×1.1×1.1×1.1×1.1x.05 = £48.32

With the pension, our chap can put in the £1,000 from his salary tax-free. However, he must pay 40% tax at the back-end. This time, we get:

• £1,000×1.1×1.1×1.1×1.1×1.1×0.6×0.05=£48.32

The same!

Important caveat: Things are NOT equal

I’ve shown there’s no difference between an ISA and a pension from a pure maths standpoint.

But I said that was with ‘all things being equal’. And things aren’t equal!

Caveat 1: Lower-rate taxpayer in retirement

Most people pay a lower-rate of tax in retirement (20%). This can make a pension a better option than an ISA for higher-rate taxpayers who will be lower-rate taxpayers in retirement, because the rate they pay on withdrawing the money (20%) will be lower than the relief they got on when they put the money in (40%).

In the worked example above, instead of multiplying by 0.6 to represent the tax on withdrawal, you’d multiply by 0.8, which gives a much higher income of £64.42.

Caveat 2: Tax-free lump sum with a pension

A second important factor is that you can take out a one-off 25% lump sum entirely tax-free with a pension. This means you get tax relief going in, and yet pay no tax on that 25% later – the best of both worlds! Again, this gives pensions an edge over ISAs.

Caveat 3: Employers like pensions

Employers often contribute to pensions, which can be a substantial advantage, and there are National Insurance savings, too. Pensions are also better protected if you lose your job and need to claim benefits.

Pensions versus ISAs: Same but different

Set against these advantages are the restrictions on pensions.

There are strict rules on what you can do with your pension pot, and when and how much you can withdraw from it. With an ISA, you can spend your money how and when you like.

At least nowadays you’ve more choice over how you invest your pension contributions. This has got rid of a big problem suffered by previous generations, who simply made pension fund managers rich!

Today, a cheap, flexible stakeholder or Self Invested Personal Pension based around tracker funds or an ETF portfolio is the best savings vehicle for retirement. (Expensive, poorly-performing pension funds are not!)

ISAs are best used for all-purpose savings, or to back up your pension contributions, or to spread the regulatory risk of government fiddling.

One final, final, caveat: If you’re self-employed, the absence of employer and NI benefits to your pension may mean you prefer to use an ISA first, and plan to top up your pension later. (At least that’s what I do).

For more on all these other issues, subscribe to get my upcoming pensions versus ISAs series.

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