Author: Ray Prince
Source: download
Let's look at a recent client we worked with, James, a
45 year old dentist who had ฃ500 per month to invest.
James was confident that he could invest this money
until his retirement at age 60, in 15 years time.
He has a mixture of PEPs and ISAs, with an NHS Pension
and a buy to let property.
Looking at this as one investment against another, we
need to look at a like on like projection. So we will
use a growth figure of 6% net of charges for both
investments.
Because of the tax relief available for James at his
highest rate (40%), the amount he can invest into a
pension fund is ฃ835 pm compared to the ฃ500 pm to an
ISA. Using projections of the future fund values over
15 years we get figures of:
Pension - ฃ238,810
ISA - ฃ143,000
It appears there is no contest, however, let's look
at the figures a little closer.
The ISA fund is all available as tax free cash, whereas
the Pension fund rules say a maximum of 25% of the fund
can be taken as tax free cash which is ฃ59,702.
So if we calculate ฃ143,000 minus ฃ59,702 = ฃ83,297,
this is the amount of tax free cash we have over and
above the Pension route. The remaining ฃ179,107 in the
Pension fund has to be used to buy a pension called an
annuity. So the question now is what pension amounts
could be available for James?
Taking an average example and using today's rates, a
level pension of ฃ9,117 per annum would be achievable.
However, will James be a higher or lower rate tax payer
in retirement? This changes the picture somewhat, as the
following after tax pensions would be applicable:
Higher rate tax payer - ฃ5,470 per annum
Lower rate tax payer - ฃ7,111 per annum
So to compare this to the ISA, we need to see how many
years the pension needs to pay out to reach the ฃ83,297
value of the ISA fund, allowing for growth on the ISA
fund at the same 6%, net of charges.
The answer is 17 years for the basic rate payer and 30
years for the higher rate payer! Not only is this is
a massive difference between the two, but it also helps
towards the decision whether to invest into a pension
tax wrapper or an ISA.
Other considerations
-We have ignored any "pension drawdown" option
-The amounts you can contribute to pensions is currently far more generous than that available to ISAs
-Annuity rates, income tax bracket, on pensions may improve or reduce in the future
-The government may change the rules on either pensions or ISAs or even abolish the tax favourability on one or both
-Financial Advisers/Salespeople are often paid higher initial commission on pensions than ISAs so make sure your adviser is taking these factors into account, and not just selling you a policy that pays him/her the highest commission.
So what did we advise James to do?
In his case it all came down to the picture painted
by his cash flow model. This enabled us to see how
James's wealth would look in the future.
What was clear was that his NHS Pension would in itself
take James into the higher rate tax bracket, and that a
tax free cash fund was more attractive to him than more
income that would be taxed at 40%. It would also aid
James to gift money to his 2 children, to both help them
financially and reduce his likely Inheritance Tax liability.
Therefore, James invested monthly sums into an investment
Maxi ISA.
The Financial Tips Bottom Line:
In effect, there is no clear cut right or wrong. It always
comes back to balancing the pros and cons of all the options
available and making your decision based on thorough research.
Ray Prince is an Independent Financial Planner with Rutherford Wilkinson plc, and helps doctors and dentists get the best deals on mortgages, protection and investments, as well as helping them achieve their financial objectives.
Get your free retirement planning guide, exclusively for UK Resident Doctors and Dentists. Just visit http://www.financialtipsonline.com/ea3. You'll also receive the twice-monthly email newsletter 'Financial Tips' that will enable you to keep posted of all financial issues affecting doctors and dentists. He can be contacted on 01670 505522.
Rutherford Wilkinson plc is authorised and regulated by the Financial Services Authority.
