Why Pensions Should Still be Attractive for Savers
Every year in the build up to the Budget, there is usually plenty of speculation that Pensions will be a target, whether it’s the tax relief applied on contributions or the benefits available, and this can lead some to making drastic pre-emptive decisions (you only need to Google: pre Budget pension panic).
Certainly, this last Budget was subject to far more speculation than usual, not helped by the press who seem to have an insatiable appetite for inflating think tank ideas into a nailed-on certainty!
However, the one change that was widely anticipated did make the Red Book, labelled a reversal of a Tory loophole, pensions falling into scope of the Inheritance Tax (IHT) net. This has led many to asking if pensions are still a good savings vehicle.
The answer for most people is almost certainly "Yes" – pensions will remain the most efficient way of saving for retirement compared with other tax wrappers. Even those who will never need the pension for income purpose and intend to pass their pension pot down to future generations are still likely to provide a greater inheritance by saving into a pension.
Pensions vs ISA for Retirement
To consider the effectiveness of pension saving we have compared it to its nearest tax privileged rival – the ISA.
Both pensions and ISAs protect savings from Income Tax and Capital Gains Tax. It’s the tax relief on contributions and tax-free cash available on withdrawals that set them apart.
This presents a compelling argument in favour of funding pensions before ISAs where the goal is retirement income. Only individuals taking withdrawals containing no tax-free cash and paying tax at a higher rate on withdrawals than tax relief received on contributions will be potentially worse off. However, this scenario will be the exception and not the rule. Most individuals will pay tax at a lower rate in retirement than when they were working.
For example, a gross pension contribution of £16,667 would cost a higher rate taxpayer £10,000. Ignoring growth, the return when withdrawn in retirement, even if the individual is still a 40% taxpayer, is £11,667 (£7,500 income after tax plus £4,167 tax-free cash). The same £10,000 invested in an ISA will still be £10,000 when taken. The spendable pot from the pension after all taxes is therefore 16.67% more than an ISA simply because of the tax treatment.
The table below looks at a sample of returns where the rate of tax relief on contributions is greater or equal to the Income Tax on withdrawals:
| Tax rate when paid in / tax on withdrawal | Gross amount invested in pension | Pension return after tax | ISA return | % increase |
|---|---|---|---|---|
| 45% / 40% | £18,182 | £12,727 | £10,000 | 27.27% |
| 45% / 20% | £18,182 | £15,455 | £10,000 | 54.55% |
| 40% / 40% | £16,667 | £11,667 | £10,000 | 16.67% |
| 40% / 20% | £16,667 | £14,167 | £10,000 | 41.67% |
| 20% / 20% | £12,500 | £10,625 | £10,000 | 6.25% |
These figures are based on headline rates of tax.
Pensions vs ISA at Death
It’s worth remembering, that not that long ago, there were no (or very little) death benefits available after age 75 when you were forced to buy an annuity or move in to Alternatively Secured Pension (ASP) where unused funds were subject to high levels of taxation.
Pensions have long been accepted as the most tax efficient way of saving for retirement. This should remain the case even after the introduction of Inheritance Tax (IHT) on unspent pension funds.
From April 2027, pension death benefits will be subject to IHT unless left to a spouse or civil partner. ISAs are similarly treated for IHT.
Where they differ is that the pension pot will have IHT deducted first, with the balance taxed at the recipient beneficiary’s marginal rate of Income Tax, if the original scheme member died at age 75 or over. Is this ‘double’ taxation a cause of concern – could it ultimately affect how people save for retirement over and above any workplace schemes?
As we have already said in the earlier example, a higher rate taxpayer could make a gross contribution of £16,667 at a net cost of £10,000. If this has not been drawn before death, it would be taxed for IHT at 40% (assuming there is no nil rate band available), leaving £10,000. But if the scheme member died after reaching age 75, there would be further tax to pay on any income drawn by the beneficiary, who would be taxed at their marginal rate of Income Tax. An Income Tax rate of 20% would leave £8,000 net.
Compared to £10,000 in the ISA, and after IHT, this would be worth £6,000, some 25% less than the pension. Even if the beneficiary was a 40% taxpayer, the net spendable amount from the pension would equal that from the ISA of £6,000.
For deaths before age 75 there would of course be no income tax charge on benefits drawn, unless paid as a lump sum exceeding the new Lump Sum Death Benefit Allowance (LSDBA).
The table below considers the outcomes for a sample of scenarios based on a net cost to the saver of £10,000 and where the scheme member dies aged 75 or older.
| Tax rate when paid in / tax on withdrawal | Gross amount invested in pension | Pension net of IHT | Pension net of Income Tax | ISA net of IHT | % increase return in pension |
|---|---|---|---|---|---|
| 45% / 40% | £18,182 | £10,909 | £6,545 | £6,000 | 9.09% |
| 45% / 20% | £18,182 | £10,909 | £8,727 | £6,000 | 45.45% |
| 40% / 40% | £16,667 | £10,000 | £6,000 | £6,000 | 0% |
| 40% / 20% | £16,667 | £10,000 | £8,000 | £6,000 | 33.33% |
| 20% / 20% | £12,500 | £7,500 | £6,000 | £6,000 | 0% |
Most clients funding pensions for wealth transfer reasons will generally be higher earners and likely to receive tax relief at either 40% or 45%, which means in most cases the pension will provide an increased inheritance for the beneficiary even after the deduction of both IHT and Income Tax.
The exception is where the beneficiary pays Income Tax at a rate greater than the tax relief received on the contributions. This could happen, for example, where the death benefit is paid as a lump sum resulting some of the death benefit becoming taxable at 45%.
Of course, most modern pension schemes will offer inherited drawdown which would allow the beneficiary to manage the income taken to keep below important tax thresholds. But it is important to ensure that death benefit nominations are up to date and will allow adult children to take drawdown and not just a lump sum.
Summary
Imposing IHT on pensions has levelled the playing field, with all mainstream tax wrappers now subject to IHT. And it leaves those that had already accumulated pension wealth that they intended to pass on with a much greater IHT liability than they anticipated.
But it certainly should not be seen as barrier to those still saving into their pension. Pensions remain one of the most tax efficient long-term savings vehicle for the vast majority of clients, whether that is for retirement or wealth transfer.
This article was prepared by Chris Green, head of our Financial Planning Team. We always appreciate your feedback. If you have enjoyed this article or have any specific topics you would like to see addressed in future newsletters, please email us.