Why A Pension Is The Best Tax Shelter… Or Is It?

Why A Pension Is The Best Tax Shelter… Or Is It?
Underwater by Andy Deitsch. Why?

If you’re considering making a tax efficient investment and you’re unsure whether to stick your money into a pension or an ISA, here’s a fascinating look at each tax shelter

In The Long-Running Pension-ISA Debate, Which Tax Shelter Is Better For You?

The Big Difference Between Each Tax Shelter

A Pension Gives You Tax Relief Up Front

You effectively invest at a discount because you get tax relief at your highest rate of Income Tax on your contributions.  But you pay tax when you draw your retirement income.

An ISA Gives You A Tax Benefit When You Cash It In

Although you don't get any tax relief on your investment, when you draw out your money in the future, it’s tax free.

What’s interesting is that if your Income Tax rate is the same, there is no tax advantage of a pension tax shelter over an ISA tax shelter.  It’s not rocket science, it’s maths, as you can see in the pink box below the illustration.

A Pictorial Comparison Of Each Tax Shelter

tax-shelter

A Mathematical Comparison Of Each Tax Shelter

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.

You’ll find full details of the pension versus ISA debate in this tax shelter article.

How To Choose Your Tax Shelter

Although it can be proven mathematically that a pension and an ISA tax shelter are equal, your individual circumstances may mean one of them could be better for you than the other. What’s confusing, however, is that this can change at different stages during your life.

Here are a couple of things in favour of a pension and a couple in favour of an ISA. 

Consider A Pension Tax Shelter

The fact you can draw out 25 per cent of your pension fund value tax free in the future, on which you will have enjoyed tax relief when you invest now, provides an obvious advantage of a pension over an ISA, particularly if you’re currently a higher rate tax payer.

If, like most SIPPclub Members, you pay a higher rate of Income Tax now, and you expect to pay a lower rate in the future, a pension is likely to come out on tops.

Consider An ISA Tax Shelter

If you intend to spend your money in largish chunks, you could find yourself bumping into unacceptably high rates of Income Tax when you draw money out of your pension tax shelter, compared to the full flexibility of withdrawals from an ISA tax shelter.

Despite being able to draw benefits from your pension at 55, an age which may well be increased in time, if you want unfettered access to your cash at an earlier age, an ISA could be the way to go.

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