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.