Yet more reasons to favour Isas over pensions

We’ve often written about our preference for Isas over pensions as 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.

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.

  • Rambler

    It really depends on your earnings and the size of your pension pot – there can be compelling reasons why a pension easily beats an ISA for your earnings. There are a number of examples I can think of:
    1. If your pension pot is quite small because you lived overseas for a long time when you were younger it would make sense to build it up.
    2. If you lived abroad and earnt a lot that could not be put away into an ISA while you were overseas. It might make sense to build your pension further while you use your ISA allowance for some of these overseas allowances.
    3. If your earnings for a period of time have a very high tax rate then it makes sense to build up the pension pot to avoid these taxes. For example, if you fall into the category of either having some earnings hit the £50,000 mark and start losing your child allowances or have earnings hit the £100,000 mark where you start to loose your personal allowance.

  • mr clyde

    Agree – ISA or pension is entirely dependent on personal circumstances. There are all sorts of permutations available using SIPPs, ISAs, even VCTs etc.

  • Ralph

    These ISA or Pension articles that appear regularly in MW always seem to favour ISAs and this is very misleading. A Pension offers many advantages over an ISA, some of which never seem to get even mentioned. Most higher rate tax payers will usually be much better advised to take the Pension route and a great many basic rate payers too.

    As others have said here, it does come down to personal circumstances but I would be surprised if many people found ISAs a better option, if they are made aware of all of the pros and cons of each.

  • rdp

    I may be wrong…do you not receive a personal allowance before any tax is taken off a pension. This is assuming you dont have any earned income. Therefore the first 10,000 pounds (personal allowance for this tax year) would be tax free.

  • Ralph

    Thanks rdp – ‘yes’ is the answer of course and there are certainly other considerations that favour Pensions too but these are never mentioned by Money Week.

    This article by MSW is actually quite typical in as much as it hasn’t been fully researched – it doesn’t show Mr Cowie in a good light either, as they have both failed to make a true and proper comparison.

    The Pension investment will have been grossed up and so more shares will have been purchased. Those shares will obviously accrue more gains for the Pension investor. 25% of the accumulated pool can then be taken tax free.

    This means that for most people the Pension route should logically be the more beneficial option, unless the individual is likely to pay tax at a higher rate when they retire than they did when they were working. I would suggest that in practice it is far more likely to be the other way around if anything and SIPPs can be a very useful tool in this regard too, as you can control income levels via Drawdown.

    In summary I would say (as others here have already suggested) that you should get advice for this sort of thing, because it is much more involved than most people think. Saving for retirement is one of the most important things to get right and although MSW generally seems to favour people going DIY (her latest article refers) this is actually a more complex area than it seems she appreciates.