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

Pensions versus ISAs from a tax perspective

There is nothing magical about pensions versus ISAs, the UK’s two tax-free savings wrappers, that somehow 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 five 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 (0-20%). 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 tax relief they got on when they put the money in (40%, or 45% for additional rate payers1 ).

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

But there’s more! You still have an annual income tax personal allowance as a pensioner. So a good chunk of your pension income may not be taxed at all. (The first £11,000 at the time of writing, presuming no other taxable income streams are complicating matters.)

On the other hand, some of your personal allowance should be used up by (hopefully) a State Pension at some point in your retirement. The State Pension counts as taxable income.

As you can see the marginal tax rate you’ll pay can be very uncertain 15-20 years in advance.

Caveat 2: Tax-free lump sum with a pension

A second important factor is that you can take out a one-off 25% lump sum2 entirely tax-free with a pension.

On this portion of your money you get tax relief going in, and yet can pay no tax on that 25% coming out later – the best of both worlds!

Again, this gives pensions an edge over ISAs.

Caveat 3: Employers pay into pensions, but not ISAs

Employers 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

In the old days – that is, three or four years ago – we’d now shift gears to talk about the huge and hidden downsides of pensions.

Gloomy organ music would rise up out of nowhere, an unseen wind would shutter the windows and plunge us into darkness, and we’d somberly recount the onerous restrictions on what you could actually do with your money that you’d saved into your pension when you were old enough to need it.

All that changed though with the 2014 Budget’s pension freedoms.

There are still some rules on what you can do with your pension pot – most particularly when you can get access to it. Currently you need to be 55, but that age climbs if you’re younger and many fear it will keep rising.

You do also need to be aware of the tax implications of different withdrawal strategies.

In contrast, with an ISA you can spend your accumulated money how and when you like. It’s always tax-free.

But still, when it comes to how you invest your pension pot once you’ve retired and how you withdraw it, most of the old strictures are gone.

Most dramatically, you’re no longer compelled to buy an annuity. You can instead invest your pension in other assets to create an income that suits you.

Famously, you can even withdraw the money to buy a Lamborghini if that floats your boat.

Our contributor The Greybeard has been covering this brave new world of pensions and deaccumulation. Please do check his articles out.

The changes mean that most people on a fairly normal retirement path will conclude that a low-cost pension based around tracker funds or an ETF portfolio is the best vehicle for retirement savings.

My co-blogger The Accumulator certainly thinks pensions have the edge.

ISAs are still massively valuable for all-purpose savings. They can also back up your pension contributions, and diversify the risk of future governments fiddling with the rules.

And if you want to retire very early, ISAs will probably have to feature heavily in your strategy, given the age restrictions on accessing pensions.3

In an ideal world you’d have both a pension and ISAs. But whatever you do make sure you’re using some sort of shelter to stop tax reducing your investment returns.

Note: Older comments below may pre-date the pension freedoms. Check the dates! Also I’ve not gone into Lifetime ISAs, as there are signs that the government is already having second thoughts about the inherent inconsistencies in this halfway house. If they are implemented we’ll come back to them, so please do subscribe for updates.

  1. But beware of reduced annual allowances if you’re a high-earner. []
  2. Technically it’s called a Pension Commencement Lump Sum, or PCLS. []
  3. If you’re trying to retire in just ten years say, then the annual ISA contribution limits are going to be a snag. Make sure you’re fully up-to-speed on capital gains tax strategies and the like. []

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{ 104 comments… add one }
  • 100 L November 29, 2016, 9:50 am

    Another benefit of salary sacrifice into a pension (not sure if it has been mentioned already), is that it reduces student loan repayments, useful for people on national average wages (say £30k) trying to bump up their retirement savings. I’ll happily have a bit more in my pension vs. a lower student loan debt at 1.5%? Or so interest.

  • 101 WestCountryEscapee November 29, 2016, 12:56 pm

    @David – the £7500 limit sounds good for Airbnb’ing the spare room!
    If you are freelance and work for a limited company then the pension has numerous advantages: you can contribute £40k per year free of NI, personal and corporation tax or more if you have not used the allowance for previous years.
    Of this £40k, you can contribute up to your PAYE salary limit as employee contributions and get a 25% immediate benefit with a corresponding uplift in the higher rate tax limit.
    The combination of these two makes it easy to maximise your contributions whilst minimising your personal tax, i.e. staying below higher rate – provided your lifestyle supports it!

  • 102 Erith December 2, 2016, 4:58 pm

    Great article, and food for thought.

    On your Pension v ISA example on tax, as you say, you can be smart about withdrawing enough to keep you under tax thresholds, but as I understand it, when you ‘crack’ your pension pot, you also get 25% of the ‘pot’ tax free, either as a lump sum, or in each withdrawal.

    There is also an opportunity cost to consider when investing.
    Let’s say you have post-tax cash of £1,000 to invest, and you are a 40% taxpayer.
    Your £1,000 put in a SIPP, gives you £1,668 because the tax man gives you the tax back. After 40 years at 10%, you get ~£75k
    Your £1,000 in an ISA, is still £1,000. After 40 years at 10%, you get ~£45k
    The cost to you today is exactly the same.

    Assuming you are not clever and pay 40% tax on your SIPP, (after your 25% tax-free lump sum) you get £52,500 – a clear win. If you manage to only pay 20% tax you get £63,750.

    For me the difference is in flexibility, and also aspirations on when you wish to retire. I am counselling my (Millennial) children to put as much into a SIPP as they can just now, but also make some ISA savings (80/20 rule). The ISA’s give them flexibility, but the SIPP gives them immediate returns in the increase in the investment amount. They can review this in a few years when they understand better what their own family & retirement plans are.

    And of course, given the latest tax rules, my remaining pension pot can now be left to them….

    Off to do some more maths myself!

  • 103 Jonathan August 13, 2017, 8:09 pm

    Pension pots have some significant advantages. For one, they’re recognized in double-taxation treaties (and even when there’s no treaty, countries usually respect the tax-exempt status of investment returns within the pot), so pension-based retirement saving for those planning to work abroad is best. An ISA is just some weird British tax-protection wrapper, which won’t help you if you emigrate and settle elsewhere.

    Pension pots are well-protected against adverse court judgments and bankruptcy proceedings. Pension pots are invisible to benefits means tests.

  • 104 David October 14, 2017, 7:32 pm

    I am considering taking out A.V.C with my council employer duration 10 years to add to my pension scheme which will attract tax relief. Cost 1pc annual charge with Prudential are there better ways to save

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