Do you want a piece of one of the most successful stock markets in the world? Well, do you? I suspect so, which is why we’ve put together this guide to the Best S&P 500 ETFs and the best S&P 500 index funds.

In this post, we’ll explain how to pick the best S&P 500 trackers and narrow down the array of choices to a worthy few. 

Best S&P 500 ETFs – compared 

Source: Trustnet and fund provider’s data. Returns are nominal annualised returns. 

S&P 500 ETFs are a type of index fund that track the performance of the 500 largest stocks in the US.1

Index funds are designed to match – as closely as possible – the return of a particular section of an investible market. The part you gain exposure to is defined by the ETF’s benchmark index. That’s the S&P 500 in the case of the trackers we’re focussing on today. 

By replicating the performance of their index, S&P 500 ETFs (and S&P 500 index funds) enable you to efficiently diversify across Corporate America’s most profitable companies at minimal effort and for an incredibly low cost. 

Our post on ETFs vs index funds explains the key differences between the two types of investment tracker.

There isn’t normally much to choose between the two tracker flavours. But when it comes to the US stock market, the best S&P 500 ETFs are superior to the best S&P 500 index funds. 

Best S&P 500 ETFs – what to look for

The table above lists the key criteria that separate the best S&P 500 ETFs from the also-rans.

As you can see from the 10-year return column, the practical difference between the top dogs is extraordinarily slight.

That said, it’s not quite like picking baked bean tins off the supermarket shelf. Some S&P 500 trackers are more equal than others…

Replication 

The ETF’s index replication method matters when it comes to US stocks. 

That’s because the best S&P 500 synthetic ETFs have the edge since they don’t have to pay US withholding tax on dividends. 

Contrast that with physical ETFs domiciled in Luxembourg. These must pay 30% withholding tax on US dividends. Irish-domiciled ETFs pay 15%.

(The withholding tax advantage helps explain why the physical ETFs in the table are both based in Ireland.) 

Though the two physical ETFs listed above (from iShares and Vanguard) are marginally ahead over 10-years, it’s a different story across the longest timeframe we can get data for:

Source: justETF. Returns are nominal cumulative return. 

Over 13 years, the three synthetic ETFs get their noses in front of the physical iShares S&P 500 ETF (the red bar). And the Vanguard ETF drops out of the comparison. It wasn’t launched until 2012. 

The synthetic ETF’s tax advantage springs from the interaction of US legislation and the design architecture of this type of fund. It’s not a dodgy loophole.

Indeed, fund houses that traditionally specialise in physical replication have been forced to launch their own synthetics in order to compete.

What is the difference between a synthetic and physical ETF?

As you’d expect, a physical ETF actually holds the underlying stocks that comprise its index. No surprise, since that’s the most direct way to mimic the performance of a benchmark. 

In contrast, a synthetic ETF delivers its index return by using a financial derivative called a total return swap.

Essentially, a swap is a contract agreed between the ETF provider and a counterparty – usually a large global financial institution.

The counterparty pays the ETF provider the index return to be passed on to the fund’s investors. In exchange, the counterparty receive collateral and cash which they hope to make a tidy profit on.  

US legislation exempts swaps from incurring withholding tax when they’re applied to certain stock market indices, including the S&P 500 and the MSCI World. 

Costs 

Index trackers beat active funds on average thanks to their lower costs.

Higher fees subtract from returns. They negatively compound to drag down your profits over time. 

It follows, therefore, that lower-cost ETFs and index funds should dominate their pricier brethren. 

The most visible measure of cost is a fund’s Ongoing Charges Figure (OCF). ETF providers compete on this measure in a ceaseless price war that does have a winner – the consumer. Yay!

But the OCF is not the last word in performance. Take a look at this chart:

The graph shows the cumulative return of the cheapest US large cap ETFs (including non-S&P 500 indices), with their current OCFs overlaid in green. 

We’ve also added Xtrackers’ S&P 500 Swap ETF 1C. This is one of the most expensive S&P 500 ETFs around – and yet it is also a top performer. 

There’s no clear correlation on OCFs here. Rather, the point is that the cost gaps between the best S&P 500 ETFs (and rival indices) are so slim that they’re not a deciding factor when it comes to performance. 

By all means choose a keenly-priced tracker. But don’t stress about every last pip of difference. 

Long-term returns

Naturally we’re drawn like groupies to the best performers on the stage. 

But two points of caution.

Firstly, the current Number One may not lead the pack in the future. There’s just no guarantee that any small advantage eked out today will persist. 

Additionally, as the next chart shows the difference between leading S&P 500 ETFs is marginal anyway: 

All of these ETFs have delivered exceptional performance over the last 11 years, because they mirror the S&P 500. And these US large caps have produced stellar returns over the period. 

Every single one of those trackers did its job. True, we can see that some did it slightly better than others – in hindsight and with our magnifying glasses out – but you don’t need to get Sherlock Holmes on the case when you’re choosing between me-too products.  

Note that every table and chart in this post uses a slightly different timeframe. And the single best S&P 500 ETF – as measured by return – changes with almost every time period. 

There is a core set of five ETFs that have maintained a slight edge (as reflected in our Best S&P 500 ETFs table). But performance is only one factor worth thinking about.

Also, forget about any conclusions drawn from less than three years of data. The longer the timeframe, the better the perspective. Temporary wins are planed away by the law of averages. 

Our approach is to find the best long-term data we can, then place our pick in the centre of the Venn diagram of relevant factors.

A balance of low cost, long-term performance, and an ongoing tax advantage will get you to the right place. 

Best S&P 500 and US large cap index funds – compared 

Source: Trustnet and fund providers’ data. Returns are nominal annualised returns. 

There are many fewer S&P 500 index funds available than ETFs. Hence we’ve drafted in other flavours of US large cap tracker fund to bolster your options.

You can see that the best S&P 500 index funds trail the best S&P 500 ETFs over the long-term.

But the lag isn’t egregious and is worth living with if you’ve chosen a percentage fee broker that offers zero-cost trading on index funds, since you’ll be saving extra dosh that way on investing fees.

Once your portfolio is worth over £12,000 in a stocks and shares ISA – or roughly £60,000 in a SIPP – then it’s time to think about the long-term cost advantages of switching to ETFs.

• The Monevator broker comparison table will help you to choose the best platform at either stage.

Compensating factors

Another good reason to pick an index fund is that such funds are eligible for the £85,000 FSCS investment protection scheme.

ETFs do not qualify for compensation under this scheme.

The only vehicle that is covered by the FSCS is a UK domiciled Unit Trust or OEIC (Open-Ended Investment Company).

All of the index funds listed in our table are one of those two types.

And just in case you’re wondering, index funds all physically replicate their indices. There’s no synthetic, withholding-tax-swerving option here.

Best S&P 500 ETFs vs MSCI USA ETFs

Finally, it’s worth knowing that trackers based on the S&P 500 have consistently beaten other indices that represent US large caps over the periods we’ve been looking at:

ETFs based on the MSCI USA index are the most commonly offered alternative to S&P 500 tracker funds. Our chart shows that they have consistently come off worse against S&P 500 stablemates. 

The MSCI USA is slightly more mid-cap orientated than the S&P 500. But the US tech giants have swept all before them for well over a decade, benefitting the famed US mega-cap index. 

But academic research has previously found that smaller companies in aggregate beat large companies over the long-term.

There’s reason to believe then that recent returns will prove to be an anomaly.

S&P 500 forever?

On a related note, Corporate America has been the winning bet globally for more than a decade, too.

In fact if you’re looking for the best S&P 500 ETF or index fund then you’re probably motivated by the total ass-smashing our Trans-Atlantic cousins have handed the rest of the world in recent years:

However Team USA does not always win, as shown by a longer-term analysis of the S&P 500 vs the MSCI World.

In fact the dominance of the US is likely to contain the seeds of its future reversal.

If America looks like the only market worth investing in, then returns must decline eventually as prices are bid up.

The higher the price, the less likely it is that you’ll make outsized returns – because, ultimately, there’s no reward without risk.

We can’t know when any trend will reverse. But the reason we diversify is because it usually does.

US stocks seem overvalued by the best historical measures we have – though such metrics are not bulletproof, and they don’t explain why the S&P 500 has been apparently defying gravity for years now.

The Monevator view is that it’s best to spread your bets around the world. Easier said than done though when even the best global tracker funds are now 60% concentrated in the US, thanks to the latter’s outperformance.

All the more reason to keep a good chunk of change in the best bond funds and ETFs. And perhaps to read our thoughts on the best commodities ETFs, too.

Take it steady,

The Accumulator

1. Size is determined by market cap – the total market value of a firm’s publicly traded shares. Standard and Poor’s uses a few other criteria too, which means the S&P 500 may not strictly represent the 500 biggest publicly-traded US companies. In fact, you can’t even rely on the 500 bit because the index contains 503 entries at the time of writing! [↩]

What caught my eye this week.

I have always loved the end of things. A closing down sale. A silent office over Christmas when everyone else is away. The last days of school. The siesta of working through your notice period, when however conscientiously you try to keep at it, the pressure has all gone.

Perhaps Rishi Sunak and Jeremy Hunt feel the same way. They certainly seemed to enjoy themselves with Wednesday’s Autumn Statement. The Prime Minister chortling, and Hunt showing unexpected comic timing as he shared his purported 110 supply-side reforms to unlock economic growth.

This is the Brain’s Trust of the Tory party by modern standards. Sunak and Hunt both know the odds of them being in their jobs after the next election are remote.

Hence I was pleased to see what was mostly a technocratic budget.

Without much room to play with and very little chance of enjoying the spoils, Hunt delivered a suite of pinches, tickles, and tweaks that he hopes will add up to an invigorating pick-me-up for Britain PLC.

I wouldn’t say it amounted to a grand Growth Plan. But it does at least look like planning for growth.

A welcome change after nearly a decade of throwing grit into the wheels at every turn.

When 2p goes quite a long way

Under the last two incumbents of Number Ten, this Autumn Statement would surely have been heavy with last-days-in-the-bunker vibes.

Crazy populist policies that heaped more of Britain’s long-term potential on the bonfire, Denethor-style or – presuming she had time to get them typed up – short mad missives addressed to generals and armies long since taken off the table.

There’s still the Spring Budget for that I suppose. Maybe we’ll then see the unnecessary – and at the least ill-timed – scrapping of inheritance tax, or the pantomime horse of a British ISA that doesn’t know its arse from its elbow. Or big income tax cuts that would certainly be welcome but can hardly be afforded.

But Hunt’s more modest moves were impressively sane.

Sure, cutting employee National Insurance by 2% is at bit like giving someone a stool to stand on while the floodwaters of fiscal drag are rising and the tax take inexorably drowns the land.

However it’s better than nothing, rewards work, and helps those towards the average end of the spectrum more than the rich, which is appropriate in a cost-of-living crisis and a world where disparities of outcomes are widening. Ditto the simplification of NI for the self-employed.

Unlike a general income tax cut, trimming NI also doesn’t give anything extra to pensioners, which is a good thing. I’ve nothing against old people – I hope to be one someday – but pensioners have had it relatively better for years now. And the too-costly triple-lock remains in place.

Kicking off a consultation to look into Aussie-style pension pots that move with you when you change jobs was welcome, as were the steps towards ISA simplification rather than proliferation.

And common sense seems to have prevailed when it comes to allowing fractional shares in an ISA.

We’ll have to wait for the small print on all of these – and I’d say there’s zero chance of ‘pension pots for life’ before the next election – but it’s sensible stuff.

Paying the price

The bigger picture hardly looks pretty, of course.

After the rush of reporting on the Autumn Statement goodies was over, experts lined up to explain British workers are still very much under the cosh of fiscal drag thanks to frozen tax thresholds.

In fact this Tory government will exit leaving Britain at its most heavily-taxed since the days of Churchill.

Not entirely its fault of course, with a global pandemic in the mix. We can argue about specific Covid policy responses – and I’d cut all governments a lot of slack, fiscally-speaking, given all the uncertainty – but evasive action was costly everywhere.

On the hand, the economically-witless Brexit was mostly the Tories’ fault. Who knows exactly how much it’s hammering us, but the independent Bloomberg’s third annual estimate puts it at £100bn a year.

Slap a 40% tax take on that and that’s £40bn more a year that Hunt could have had to play with.

For a sense of what that’s worth, the OBR estimates this week’s NI cut will cost £10bn a year. So we could have had four of those, say. Or an inflation-adjusted personal allowance. Or more spending on services that instead are being whittled away.

Not so much 40 new hospitals from Brexit as 40 weeks to wait to get into one. Or 40 minutes late on the train to get there.

The economic drag from our innumerate Brexit has been going on for years now. Soon enough we’ll be half a trillion quid in the hole. This was always going to be a costly whimper, not a big bang. And this is not even to count the waste of time of five years arguing about how best to shoot ourselves in the foot, versus a counter-factual where we had decent leaders who focused on things that actually mattered.

Never forget when Britain properly gets growing again that we generally tend to grow. Brexit won’t have given us that growth. It has just slowed us down in the meantime.

Oh, and I’m not much impressed by retorts that we’re growing slightly faster than Germany or doing a little better than Italy or whatnot.

For one thing, I expect that the same statistical revisions – which we’ve applied first – will boost rear-view Eurozone growth in time, too.

More pertinently, it just means we’d be growing even faster than those countries if we hadn’t the burden of Brexit.

We did fine for decades in the EU – and we were growing faster than them then, too.

Now though, we’re trundling along with a slightly flat tire – and that’s with immigration at a record high.

Immigration boosts economic growth. So we’d be growing even slower if Brexiteers had actually been able to cut numbers to the level most of them voted for.

Incompetence saved us on that score.

Poor show

The pandemic, Brexit, inflation, and Britain’s endemic productivity problem – it has all helped to squash real income growth.

According to the Resolution Foundation, by the end of this Parliament (which started with a bluster in 2019) average household income will have fallen by 3.1%. That’s £1,900 less in spending money.

It’s unprecedented in modern times:

Source: Financial Times

Still, you might imagine that with the government taking in the greatest share of economic output since World War 2 the squeeze on public services might be over, at least?

Alas not. The Institute of Fiscal Studies estimates that Government departments will need to find another £20bn of spending cuts next year.

I suppose they might yet try a pre-election borrowing binge to fund their way out of that hole. But given how the soaring cost of paying our current debt is another reason why the public finances are so strained, this would hardly be something to cheer.

The morning after the night before

I said on Twitter this sensible Autumn Statement suggested the Tory party had turned a corner – at least for now.

I hope so. Britain desperately needs better leadership. We can debate the right policy levers to pull, but we can ill-afford any more grand delusions.

The numbers make that plain.

Have a great weekend!

Autumn Statement roundups

What the Autumn Statement means for your money – Which

Another spin on the same – Be Clever With Your Cash

FT has a solid take on The Autumn Statement [Search result] – FT

Here’s a perspective from the lefties… – Guardian and its calculator

…and the same with a calculator more from the right – This Is Money

And commentary

What is national insurance, and who will benefit from its cut? – Guardian

Britain’s tax burden to be highest since WW2 despite NI trim – This Is Money

Will fiscal drag wipe out your national insurance gains? – This Is Money

How to fix Britain’s flashy economic announcements [Search result] – FT

Hunt delivers a budget designed to destroy a future chancellor – Guardian

It alleviates the worst pain, but it won’t fix Britain’s underlying problems – Prospect

The collated #autumnstatement tweets of Martin Lewis – Independent

[continue reading…]

The reason to encourage pension contributions from the government’s point of view is to get more people to save for their old age and so to not be dependent on the state.

But the reason to make pension contributions from our point of view is to minimise the amount of tax we pay over our lifetimes.

After all, we can save for old age in all manner of ways. Locking up money within a pension therefore requires an extra incentive – and the opportunity to save tax is that push.

In principle, defined contribution (DC) pensions are pretty simple:

• You contribute to your pension ‘gross’ of tax (i.e. before income tax is taken off).
• Your pension pot grows tax-free.
• Finally, you pay tax on the withdrawals at the time you take them.

All else being equal (especially your tax rate while working and your tax rate in retirement) this is a tax deferral strategy.

Pensions only turn into a tax mitigation strategy when we get a higher rate of tax relief on pension contributions than we pay on drawing the income in retirement.

As finance nerds, we want to maximise the ‘spread’ between these two rates, with as much money as possible, with the least possible risk. 

Show me the OAP money!

With the abolition of the pension Lifetime Allowance (LTA) – which we’ll come to – I sat down to work out the optimal pension contribution strategy.

It should have been easy, right?

All you need to do is:

• Work out your marginal tax rate to drawdown money from your pension in retirement as a function of pension pot size.
• The bigger your pot, the more income you’ll need to draw, and the higher your tax rate on drawings. 
• Discount those pot sizes back to today using your expected investment return in the pension.
• If your current marginal tax rate is above the extraction tax rate for the pension pot size that you currently have (discounted back to today), then make contributions. Otherwise don’t. 

Hence all I needed to know was: when I’ll retire, the tax regime that will be in place then, how long I’ll live, and what my investment returns will be before and during retirement. 

Ahem. Perhaps not surprisingly: I failed.

However my analysis turned up some titbits that I’ll share today in the hope they’ll help some of you, too.

A recent Monevator poll showed a majority of our readers are higher- or additional-rate taxpayers.

And with income tax thresholds frozen and inflation dragging more people into higher tax brackets that number is only going to grow.

Rich people’s problems

What we’re trying to optimise with our pension contributions is this:

Now, for the purposes of this post we’re going to pretend that we live in the idealised world of finance professors.

In this textbook world we can:

• Move money across time at the same discount rate.
• Borrow, lend, and invest arbitrarily large amounts of money at this rate.
• Afford to make tax optimal pension contributions without considering anything else.

Therefore the only consideration we are making in this article is maximising the spread between contribution tax relief and the tax rate on extraction.

This is a highly simplifying assumption. But it is a reasonable approximation for fairly rich people. For everyone else, not so much. (You can’t buy food with money you’re not going to get for 20 years.)   

I’ve also sort of implicitly assumed that you’re making decisions about pension contribution rates after you’ve already filled your ISA (and your spouse’s).

This is also highly unrealistic. It’s quite an ask to come up with £40,000 of post-tax income to put in an ISA, whilst also making maximally tax-efficient pension contributions.

Happily though, that is my situation and therefore the one of most interest to me.

For most people there’s a trade-off between ISA and pension contributions. The discussion that follows might help you weigh up the balance for your own situation.

Please note and to avoid me having to repeat myself: everything I’ve written below is under the current rules. (Until we talk about future policy uncertainty, clearly.) 

Also remember that the tax code is thorny and everyone’s circumstances differ hugely.

Get professional tax advice if you need it. This article is all just food for thought.

The basics: direct contributions vs salary sacrifice

Let’s start at the beginning. How do you best pay into your pension?

Direct contributions

You write a cheque to your SIPP provider for £80 and they gross it up by the basic tax amount. Which means you end up with £100 in your SIPP.

• This is a ‘net contribution’ of £80 and a ‘gross contribution’ of £100.

The distinction is important when we get to the limits on contributions and so on, because what counts is the £100 number, not the £80.

Now, if you are a basic-rate taxpayer that’s it. You’re all grossed-up, so to speak.

If you’re a higher-rate taxpayer or above, however, then you report this (gross) contribution on your tax return. HMRC adjusts your (gross) income down by the amount of the (gross) contribution, and you’ll be owed a refund.

For example, if your marginal tax rate is 40%, then you’ll get a  refund of £20 on your £100 gross. Which makes the effective ‘cost’ of putting £100 into your pension just £60.

• You write a cheque for £80, you have £100 in your pension, and you get a cheque back from HMRC for £20. Net cost: £60. 

That the contribution is used to ‘reduce’ your income from a tax point of view is important.

Crucially, if you’re in the 60% tax bracket – between £100,000 and £125,140 – then you effectively get 60% tax relief on your contributions. (Because reducing your income gets some of the annual allowance ‘taper’ back, which is the cause of the 60% rate in the first place.)

For completeness, if you’re a 45% taxpayer:

• You’ll get £25 back from HMRC when you file your tax return. 

Taxed from every angle

In practice, you may find you pay multiple rates of tax relief from a single contribution.

For example, if you earn £150,000 and make a £60,000 contribution, that contribution will experience tax relief in part at 45%, 60% and 40% rates:

Salary sacrifice

The other way to make pension contributions is to sacrifice some of your salary. Here you instruct your employer to pay some proportion of your pay into your pension scheme instead of to you.

The important difference with this arrangement is that there is no National Insurance (NI) due on this payment, because it is not ‘pay’.

Now nominally this might not sound like a big deal. Employees NI is only 2% (mostly).

Still every little helps, as you can see in the table below.

But you saving a few quid is not why your big-hearted employer is always sending you emails extolling salary sacrifice as a way to pay for electric cars, bikes, pensions, and goodness knows what else.

No. Your employer is motivated by the 13.8% employers’ NI that it doesn’t have to pay on whatever you salary sacrificed into your pension.

Your employer saves £13.80 per £100 of salary sacrifice. So probably the most important question in this whole post is: can you get your employer to share some of that money saved with you?

Well, can you?

It depends. Some employers do it by default. Others don’t. And some – big and small – will negotiate.

For my part I’ve successfully negotiated a sharing of these savings either firm-wide or as a special deal for me (“I won’t tell anyone else”).

You do have some leverage. After all, you can just make a direct contribution. It’s 2% more expensive for you, but 13.8% more expensive for them. When we approach the limits of maximising the amount of tax we save it turns out it’s highly sensitive to the ability to clawback some employers’ NI, so I’d encourage you to go for it.

Usually, any sharing of these savings goes into the pension contribution, rather than as (taxable+NI) cash to you – otherwise the process is a bit circular.

This makes the maths a bit weird, because we’re now ending up with £113.80 in the pension for each £100 of salary sacrifice:

If we renormalise that back to the cost of £100 in the pension we get this: 

The ‘gross contribution’ if you sacrifice £100 of salary and your employer pays £113.80 into your pension is £113.80, not £100. 

If we’re hitting our peak tax mitigation potential – that is, inside the 60% bracket – then we are foregoing just £33.39 in net pay to get £100 in our pension.

Employer matching

There’s a legal obligation for your employer to make pension contributions on your behalf, and to deduct a minimum contribution from you. It is usually something like they pay 4% and you pay 4%.

You can opt-out of this (I believe…) but why would you? It’s pretty much free money.

Given that your employer-matched contribution is processed as salary sacrifice, you end up with this: 

There’s pretty much no extraction tax rate on drawdown that would render these contributions not worthwhile.

Indeed, during my pension wilderness years enforced by the LTA, the employer match was all I did. 

Employer pension schemes vs SIPPs

A common complaint I hear about salary sacrifice (SS) is that you can only SS into your employers’ chosen pension scheme.

The scheme with poor investment choices, obscure fees, and a website unchanged since the late 1990s.

Well yes but this is trivially surmountable. Just set the investment choice in the company scheme to ‘cash’ and every six months or so transfer that cash from your company scheme to your favoured SIPP.

Your company won’t care. (Probably.)

Contribution limits

There are limits to how much you can contribute to your pension.

The limit is the lower of:

• £60,000
• Your total employment income

Note this limit is on the size of your gross contribution. 

The £60,000 limit is ‘tapered’ (it becomes less) if you earn over £200,000 – or £260,000 because the rules are, inevitably, pointlessly complicated. 

There is also a mechanism called carry back that allows you to carry forward (I know…) your unused allowance from previous years, for up to three years.

Handy if your earnings are very volatile.  

Summary: getting the money in 

We’ve established the cost of getting money into our pension scheme:

It’s worth noting that if you’re subject to the ‘High Income Child Benefit Charge‘, have things like childcare tax-credits, or you earn income from residential property (with a mortgage) then your marginal tax rate could be higher.

It might even exceed 100%. 

An example of what not to do: what I did

The challenge is that you don’t know the future. Specifically, you don’t know your future earnings.

You want to concentrate your contributions in years when you have the highest marginal tax rate.

But when will that be?

What you really want to avoid is a situation where you’re getting tax relief at, say 40%, but you could (later) fill your pension with tax relief at, say, 60%:

This is not far from my situation actually.

High earnings and acute imposter syndrome early in my career meant I contributed large sums to get 40% tax relief.

Later on I didn’t contribute – even though I could have got 60% tax relief – because I was over the LTA.

In my defence, when I made those original contributions the maximum income tax rate was 40%. We didn’t have the 60% band. Indeed, we didn’t have the LTA!

Still, I should have been more patient. 

This rather emphasises the point that over long time periods there’s enormous policy uncertainty.

The pension pot then grows tax-free…

…or does it, really?

I would argue not.

Sure, from an administrative point of view you don’t have to pay capital gains on any gains or income tax on dividends (except on some foreign dividends).

However in the end you will have to pay income tax on your gains – even if those gains only kept up with inflation.

And income tax rates are higher than both capital gains tax and dividend tax rates.

Then there’s the possibility that the government will just decide to confiscate some or all of the gains, in this supposed ‘tax-free’ wrapper. Which they have done before with the LTA. 

So, I’m unconvinced.

Given there exists a perfectly good actual tax-free wrapper – the ISA – I would argue that the allegedly ‘tax-free’ growth in the pension is not, by comparison, tax-free. 

The ‘tax-free’ ness of investment returns in the pension pot should be ignored when considering the spread between inbound tax relief and outbound tax paid.

This is not to ignore the impact that investment growth has on our capacity to withdraw under certain tax thresholds, or to be subject to any future LTA charge. These considerations do very much matter. They should feed into our estimates of the extraction tax rate.

Perhaps a reasonable base case is that our investments keep up with inflation, but that tax allowances do not. (Reasonable because this has been the situation for many years).

Cashing out

At last the fun bit!

Kerching! Et cetera et cetera.

Actually, while spending your pension pot is certainly more agreeable than doing without in order to fill it, in the meantime we’ve yet more maths to do.

Moreover it turns out that working out the tax relief we’ll get in on the way in was the easy bit.

Now we need to guess estimate work out our marginal tax rate in retirement, when we come to extract that cash from our pension. 

The tax-free lump sum

Thanks to the pension commencement lump sum (PCLS) – sometimes just called the tax-free lump sum – you can withdraw 25% of your pension tax-free, up to a limit of £268,275.

Effectively if your pension pot is going to be worth less than £1,073,100, then you can just assume your tax rate for withdrawals is 75% of your actual tax rate.

For example, you retire with a £1,000,000 pension pot. You pull £250,000 out tax free, and pay 20% on the rest (by spreading the withdrawals over many years).

• Your marginal tax rate will be 75% of 20% = 15%

Great, that’s lower than the rate of tax relief we got putting the money in, regardless of the circumstances. (See the chart above. The lowest amount of tax relief possible is 20%). 

Getting a camel through the eye of a needle

The larger your pension pot though, the harder it is to drawdown at low tax rates.

In fact, given the low threshold for higher-rate tax (£50,270), your investment returns can be mediocre and yet you can still reach (non)escape velocity – where you’re only drawing down investment returns, and never ‘shrinking’ the pot. 

If you do need to choose between pension and ISA savings then you also need to think about this dynamic. Don’t just pour all your savings into pension contributions. Because of the cap on the PCLS, the key inflection point is when your projected pot is on target to exceed the old LTA limit of £1,073,100.

Summing up

Putting it all together, we can calculate the ‘P&L’ in tax savings. By which I mean the number of post-tax- pounds we’re better off as a function of tax-relief on the way in and tax-rate on the way out…

…depending on if our pot is below the old LTA limit:

…or above it (LTA extraction rate at 55% included for completeness):

Avoiding over-saving

A shortcut is to think about worst case scenarios. In particular, what we’re trying to avoid is the situation where we’re paying a higher rate of tax on withdrawing than we got in tax relief:

Don’t touch it

There’s another option to consider, too.

People who are lucky enough to have lots of other assets to draw on can simply never draw their pension down at high tax rates. They can just leave it in there, growing.

Your beneficiaries can then draw it down at either 0% or their marginal tax rate, when you are gone. It’s outside your estate for IHT purposes.

We’ll discuss this a bit more below, because I believe it is very likely these rules will be changed.

For me personally – with kids, and with about a 25% chance of dying before the age of 75 (and a 100% certainty eventually) – this is quite a valuable benefit.

But won’t they change the rules again?

Yes of course they will.

So what tinkering might we anticipate in advance?

Reintroduction of the Lifetime Allowance

Bringing back the LTA is an odds-on favourite because the Labour Party immediately committed to its reintroduction when the Tories abolished it. (At least, for everyone who doesn’t work for the NHS.)

With that said, they’ve not been particularly vocal about it since. Perhaps now that the detail about the limit on the tax-free lump sum has sunk in it seems less of a priority?

After all, if you’re constraining the amount of tax-relief that high earners can get on the way in, and the amount they can get out tax-free, it’s not obvious that the LTA justifies its considerable complexity.

On balance I think it’s likely that a long period of ‘consultation’ about pensions will ensue. If they don’t re-introduce the LTA then that consultation is likely to include at least one of the other possibles I’ll get to. 

Countermeasures 

• Don’t save too much in your pension. Focus on those very high tax rate years.
• Only contribute if your tax relief on contributions is so high that you’ll still come out ahead even if you’re subject to the LTA charge .
• Historically there have been ‘protection’ regimes available if the value of your pension is above the LTA when they introduce it. This is so they can pretend that the LTA is not, effectively, retrospective taxation. (Although of course it is, even if you’re below the LTA limit when it gets introduced).
• Have the lower return assets in your pension and higher return assets in your ISA. (You should do this anyway.)

Changes to inheritance tax treatment / beneficiaries pensions 

As we’ve seen, one of the major benefits of getting money into your pension is that, under the current rules, it’s outside of your estate for IHT purposes.

I have discussed previously how wealthy families are already using this as an inheritance tax avoidance strategy. (That earlier post also goes into the mechanics of how). For those who are still working and whose estates would likely be subject to IHT, this is a very attractive planning vehicle. It enables them to get very high rates of tax relief. The result is a highly tax-efficient ‘trust fund’-like pot, which either they or their heirs can access.

It’s unlikely, for legislative reasons, that pensions will be brought inside the IHT net. The most likely change is that full tax-free withdrawal by beneficiaries if the benefactor dies under the age of 75 will be removed, and the same rules apply regardless of their age at death.

Indeed this might actually happen anyway as part of the LTA abolition.

Pensions would still remain very useful from an IHT planning point of view. The beneficiaries can drawdown when their marginal tax rate is low, for example. Or they can just treat the whole thing as an emergency fund that they can get at if they really have to (and pay the tax to access it). 

Over the long run I doubt having ‘beneficiary’ pension pots that can compound tax-free for decades or even centuries would survive the “So-and-so has £1bn in their pension” headlines. We are not America.

Talking of America, another proposal occasionally raised is to force beneficiaries to take a certain fraction of their pot as taxable income every year. These are called required minimum distributions.

But let’s not give our politicians any ideas by discussing that further here, eh?

Flat-rate tax relief

The tax-saving benefits of pension contributions rise with your earnings, thanks to higher rates of tax relief. Because of this, many people consider the tax planning we’re discussing today as inherently ‘unfair’.

Critics argue the purpose of tax relief is to try to ensure you aren’t a burden on the state in your old age.

But high earners will save for their retirement anyway. They don’t need a tax incentive.

In contrast, because they get less tax relief, lower income people have less of a motivation to save. Yet these are also precisely the people who need more encouragement to do so.

The solution often posed by left-leaning think tanks is to offer tax relief on contributions at a ‘flat’ rate. Somewhere above the 20% basic rate, but below the 40% rate. Typically 30% is proposed.

Such a flat rate would give less tax relief to the rich and more to the poor.

Full disclosure: I’m quite sympathetic to this argument.

There would be quite a lot of complexity involved in implementing it – especially for those in Defined Benefit (DB) schemes. However, since the remaining DB schemes are pretty much all in the public sector, there’s no reason (other than fairness) as to why there shouldn’t be a different (more generous) tax regime for them.

If we can have a different tax system for people in the NHS, why not for all government employees?

Countermeasures

If you think flat relief is coming, your action depends on the tax relief you currently get on contributions:

• Are you a higher / additional / 60% rate taxpayer? Then you should max out contributions that get tax relief at those rates because in the future tax relief would be lower. 
• Are you a  basic-rate taxpayer? You should make minimal contributions now. Aim to increase your contributions when the flat rate is introduced. 

Elimination of the income tax allowance taper (60% rate)

We can all agree that having a 60% rate in between the 40% and 45% rates is ridiculous, yes? So it’s not completely impossible that some future government will agree.

Labour has committed to not raising income taxes when they form the next government. I imagine they shan’t be lowering them either!

But in a second parliament they might eliminate the taper as a quid-pro-quo for increasing additional rate tax to 50%, for example.

Countermeasures

• If you’re a 60% taxpayer then pay the 60% slice into your pension, because that relief might not be available in the future. The same slice might only attract relief at 40%, 45% or 50% someday. 

Generally higher income tax rates

A penny on income tax to “save the NHS”. Another one for “care”. Another one for our “brave boys and girls fighting in some foreign war”. Oh, and another one to send some poor sods to Rwanda.

You know the drill. Taxes pretty much only go up, as state expenditure increases faster than the size of the economy. I believe this is is best tackled by increasing the size of the economy. But growth seems to be even less popular with voters than high taxes, that are, anyway, mostly paid by someone else.

If income taxes are going up over the long term, then the last thing you want to do is defer your income tax until later. You’d be better off paying tax now.

Countermeasures

• Don’t save into your pension except at very high tax relief rates. 

Crazy things that a government might consider

All those potential revisions to the pension system seem somewhat feasible to me.

But the longer you’ve got until retirement the crazier it could get.

Here’s just a random assortment of crazy ideas you see kicked about:

• Means testing of the state pension – based on private pension ‘income’. This would favour ISA savings (which likely wouldn’t be counted) over pension income (which would). 
• Means testing of the state pension – based on ‘wealth’. Possible that pensions wouldn’t be counted, but ISAs would (as they are for some wealth-based benefits, such as unemployment benefit). Favours pensions contributions over filling the ISA. 
• The integration of NI and income tax. This obviously makes sense, because they are both just a form of income tax. A properly brave government would wrap employers’ NI in too. (Although if people really knew how high tax rates are…) The pay-off for this bravery would be much higher income tax rates which could also be applied to ‘unearned’ income such as income from pensions. Favours ISAs over pension saving.  
• ISA lifetime allowance. I wish John Lee in the FT would stop banging on about how much he has in his ISA. Because seriously, why draw attention to it? Some sort of cap on the value in an ISA that’s eligible to be tax-free would be retrospective and highly complex to administer – but when has that ever stopped them? Obviously favours pension saving over ISA saving.
• ISA allowance cut (or a real terms cut through fiscal drift). Favours getting cash in your ISA while you can and leaving pension savings until later. Perhaps when you’re on a higher marginal tax rate?
• Special tax rates for pension income / an ‘Unearned Income Surcharge’. Factor in employers’ and employees’ NI, and people in employment pay much higher tax rates than the retired. This is unfair. Rather than rolling NI into income tax, you could address this by taxing pension income at a higher rate than employment income. This has less behavioural impact, because while employed people will work less if you tax them more, retirees have no choice but to live off their pensions. Favours ISA saving over pension saving.

How to model all these risks? We can’t really. You will have to make your own assessment.

The best insurance policy is to focus your contributions where you get very high rates of tax relief. That way you will probably come out ahead in most circumstances. 

Tips and tricks with pension contributions

There’s always something more to do with a tax code as complicated as ours!

Keep it in the family

Make sure you plan your pension savings holistically with your spouse. Let’s say you stop working for a decade while the kids are small, but your partner keeps working. Once you go back to work you are both higher-rate taxpayers. You have a pension pot of £200,000 and your partner has one of £800,000.

Clearly, because of the PCLS cap, as a couple your pension contributions should take priority over that of your partner’s.

Similarly, if both your pension pots are small and one of you can get your employers’ NI through salary sacrifice and the other can’t… you know which one to prioritise.

Maybe you should even think about pensions from the perspective of your whole family, as we showed previously. 

How to get 60% tax relief if you’re a 45% rate taxpayer 

You earn £190,000 a year. You make the maximum gross contribution of £60,000 a year. This brings your taxable pay down to £130,000.

So you’re only getting 45% tax relief on the contribution. And you are paying 60% on most of that £30,000 above £100,000:

Is there something we can do to improve this situation? Well, yes, of course, otherwise I wouldn’t have brought it up.

By using ‘fallow’ years – where we don’t make a pension contribution – we can use ‘carry back’ to carry forward the unused allowance from the fallow year to make a contribution that eats into our 60% tax rate.

Voila:

This saves us £22,626 of tax over a nine-year period – £2,514 per annum – just for being organised. 

Fill your ISA with your PCLS / tax-free amount 

You want to max out your pension contributions in the last few years before age 55? This doesn’t leave you enough cash to fill your ISA?

Then you can do something like the trick I showed previously. But beware of the ‘pension recycling rule’. 

The pension recycling rule

Not targeted at my trick linked to above particularly, but if you increase your pension contributions ‘significantly’ prior to taking your tax free-amount, then HMRC has a special rule aimed at clawing back your tax relief.

Called the recycling rule, it’s designed to… stop you using pension contributions in exactly the way that Parliament intended you use them.  

Scaling salary sacrifice

Is your employer paying its NI savings into your pension? Make sure that the amount you’re reducing your salary by (to get into a lower tax bracket, for example) is less than what’s going into your pension (as used to calculate the annual contribution allowance).

For example, let’s say you earn £160,000 and you salary sacrifice £60,000.

Your employer will be paying £68,280 into your pension, including the NI savings. This is £8,280 over the annual allowance – unless you’re using carry back.

The maximum salary you can sacrifice within the annual allowance is: £60,000/1.138 = £52,724.07.

This will leave some of your earnings exposed to the 60% tax rate. Be careful.

Summary

• There are almost no circumstances where contributions to your pension that attract 60% or higher tax relief or employer matching contributions will leave you worse off in the long run. That’s true even if the LTA is re-introduced in its old form.
• Capturing some of the employer NI as part of your tax relief can make a big difference. 
• The larger your pension pot, the more you need to think about policy risks.
• Once your pension pot is over four-times the PCLS limit, there’s little point in making direct contributions at 20% tax relief.

Made it this far?

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