Pensions are a tool for retirement, right? Well yes, they certainly are that but I think they are so much more than that. With the proposed changes announced in the 2014 budget allowing pension savers to access all of their pension savings from age 55 I see real opportunities to use a pension as a savings plan.
Let’s say you are just 50 and are looking for a tax efficient way to save money to repay your mortgage. Let’s assume that, like most of our clients, you are a higher rate tax payer and so avoiding tax is of significant concern. Some people may be putting away up to the ISA allowance, now £15,000 per annum, as a tax efficient way of saving to repay their mortgage.
Personally I do not like this method because the ISA has to grow faster than the interest payable on the mortgage to make sense. And the mortgage interest must be paid out of taxed income. In such circumstances simply taking out a repayment mortgage or making lump sum repayments is a more certain way of repayment.
Up until now a pension was not a valid repayment vehicle because of the limitation on what can be withdrawn from the fund from age 55. The changes announced by George Osborne in March 2014 mean that this is all proposed to change with no restriction on the amount you can withdraw from pensions from age 55.
Let’s take two examples – in both cases the individual is a 40% tax payer, each individual invests £15,000 per year for 10 years, one into an ISA, the other into a pension. We assume the same rate of return per annum on both types of investment. It is worth noting that investor 1 would need to earn £25,000 per annum gross to achieve a payment into ISA of £15,000 per annum after tax.
| |
Investor 1 |
Investor 2 |
| Investment vehicle |
ISA |
Pension |
| Contribution per annum |
£15,000 |
£15,000 |
| Tax relief |
nil |
£10,000 |
| Investment period |
10 years |
10 years |
| Return per annum |
5% |
5% |
| Fund value at 60 |
£198,101 |
£330,170 |
I think the rate of return on the pension investment speaks for itself.
If investor 1 draws down the funds from the ISA there is no additional tax to be paid – good news then? Well, yes but there’s better news for investor 2 because although they will have to pay some tax when they draw on the funds in their pension in this example the pension investment is still a significantly better option. If you draw down the funds from your pension you are able to take a tax free lump sum of 25% of the fund value and pay tax at your marginal tax rate on the remainder. In our example, if investor 2 were to withdraw all the funds in the same year assuming they have no other income and full advantage is taken of personal allowances on a pension fund of £330,170 the net proceeds after tax free cash and income tax would be as follows:
| |
Investor 1 |
Investor 2 |
| Investment vehicle |
ISA |
Pension |
| Tax free cash |
|
£82,543 |
| Remainder of fund after tax |
|
£143,695 |
| Total income available to repay mortgage |
£198,101 |
£226,238 |
If you reinvested the net funds in VCT (Venture Capital Trusts) or EIS (Enterprise Investment Scheme) the benefits would be significantly greater as discussed in an earlier blog (Pensions suddenly become very interesting).
Of course, these examples should not in any way be considered financial advice and are used only for illustration. Appropriate professional advice should be taken before anyone makes a decision on this kind of investment. I am happy to run similar figures on a more personal basis for anyone who needs convincing that pensions are probably the best investment you’ll ever make.
Andy Parker
Chartered Accountant and Chartered Financial Planner