Yet more reasons to favour Isas over pensions

If you’re after tax-free dividend payments in your retirement, you won’t get them in a pension. You’re better off with an Isa, says Merryn Somerset Webb.

We've often written aboutour preference for Isas over pensionsas a savings vehicle. The removal of the requirement for anyone to buy an annuity and of the cap on drawdown at retirement changes the equation a little (more flexibility is good).

But Ian Cowie, writing in the Sunday Times, makes a reasonable point about the treatment of dividends inside pensions once drawdown has begun.

If you get paid a dividend outside a pension, you are assumed to have made a 10% tax payment already (via the corporation tax the business has paid). Basic rate tax payers then have no further liability, and higher rate payers have only another 25% to pay.

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But if you get paid a dividend inside a pension and then draw down the income, you end up paying more. You pay the 10% (or rather, you aren't effectively reimbursed the notional 10% via reduced dividend tax rates as you are outside a pension) and you also pay your marginal rate of income tax (rather than the lower dividend tax) on withdrawals.

"As a result," says Cowie, "equity based income is taxed first inside the fund and a second time in the hands of savers". I can see the point he is getting at here.

The notional 10% tax is a bit of a red herring, but it is true that dividends earned inside a pension wrapper in drawdown are generally taxed more heavily than those earned outside a pension (20% or 40% in a pension, 0% in an Isa and 0% or 25% outside a wrapper) but that obviously needs to be set against the full income tax relief you get when you put money in a pension. Relief on the way in. Tax on the way out.

Still, if it is a tax-free retirement you want, this tax set-up is another argument for filling your Isa every year before you spend too much time working on pension contributions beyond your occupational pension.

Merryn Somerset Webb

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast -  but still writes for Moneyweek monthly. 

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.