Why higher taxes make pension and ISA planning crucial
As the tax burden on Britons is set to reach its highest level since the 1950s, it’s increasingly important to use your tax-efficient pension and ISA allowances
- For many people in the UK, pensions and ISAs are the most attractive savings vehicles available.
- Pensions are the most tax-efficient savings option, while ISAs are simple, flexible and can be accessed at any time.
- It’s wise to use pensions and ISAs together to reduce your tax liability, and the end of the tax year is an ideal time to take stock and ensure you’re making your money work as hard as possible for you.
Britons will soon face the highest level of tax since the 1950s,1 making it more important than ever that your financial plans involve both pensions and ISAs to maximise available tax allowances and options.
As Chancellor Rishi Sunak sought to repair the nation’s finances in the March and October 2021 Budgets, he hiked taxes at the fastest yearly rate since 1993.2 Though Sunak also tried to ease some of the pain by proposing future Income Tax and Inheritance Tax cuts, individuals will still face a significant tax burden for the next few years.
In March, the biggest shock for many savers was the freezing of the pension lifetime allowance, which is already impacting thousands and will likely affect millions over their lifetime – even middle earners.
Then, in the autumn, the government announced a Dividend Tax increase of 1.25%, which means investors will have to pay more on their earnings.
These changes mean savers may need to invest more to achieve their financial goals and they must make the most of their pension and individual savings account (ISA) allowances before the end of this and subsequent tax years.
Combining pensions and ISAs is not just for those affected by the lifetime limit. Rising tax bills mean all savers should think carefully and, ideally, take advice about how much they want to save into these two popular savings vehicles.
Why you should use pensions and ISAs together
Pensions and ISAs are the most attractive savings options available to many people in the UK, and they have complementary benefits for the majority.
A pension is still the most tax-efficient vehicle available to UK savers as the government adds basic-rate tax relief to contributions, meaning basic-rate taxpayers make an immediate 20% gain on their investment. For active members of workplace pension schemes, their employer also contributes at least 3% of their qualifying earnings.
Savers into personal pensions can access their pot freely from age 55 onwards, rising to 57 in 2028. Those savers can also choose who receives their pension fund after they die, and pensions fall outside of your estate for Inheritance Tax planning.
ISAs offer tax-efficient investing, simplicity, accessibility and flexibility, which has made them a hugely popular savings option. Around £75 billion was invested in adult ISAs in 2019/20, £7.1 billion more than the previous year.3
Importantly, you don’t need to wait until you’re 55 to take money out of an ISA – you can access it anytime – so combining pensions and ISAs is a good way to plan for short, medium and long-term goals. Also, there are various types of ISA, including cash, investment (also known as stocks and shares), lifetime and innovative finance.
You don’t pay tax on interest, income or capital gains in any of these ISAs, and you don’t need to declare them on your tax return.
How to balance pensions and ISAs
These complementary benefits mean whether to save into a pension or ISA is rarely a binary choice. A flexible and tax-efficient retirement plan will normally involve a combination of savings vehicles, which could include other investment types as well.
How to balance your mix of pensions and ISAs depends on your situation and preferences.
It’s not straightforward to create the optimum mix while making sure your retirement income and estate plans are the right ones. That’s where advice can make a huge difference to your future financial wellbeing.
Here are a few things to start considering.
ISA and pensions – benefits at a glance
ISAPensionCan I have instant access?YesNo access before age 55 unless due to severe ill health or protected retirement ageHow much can I pay in?£20,000 each tax year£3,600 gross or 100% of net relevant earnings (whichever is higher), subject to annual allowance limits (currently £40,000 but can be lower for high earners)How much tax will I pay on it?No Income or Capital Gains Tax on the growth25% tax-free lump sum at retirement, Income Tax on the remaining 75%What tax relief is available on my contributions?NoneImmediate 20% available, higher/additional rate taxpayers can claim further relief via self-assessmentWhat happens when I die?Full value is included in your estate for Inheritance Tax (IHT) purposesPension funds not currently included in your estate for IHT purposes. Death benefits are tax free if paid before deceased's 75th birthday, but subject to beneficiary's marginal rate of tax if deceased was over 75 at date of death.
Using a pension to reduce tax and reclaim allowances
Another advantage of personal pension contributions is that they reduce your taxable income, which means you can avoid losing certain benefits and allowances – and have more money to save or spend. Payments into an ISA don’t provide those potential benefits as they come from your taxed income.
For example, if your net income is £125,140 or more this tax year, you’ll lose all your entitlement to the personal allowance. But by making a pension contribution of £25,140, you could reduce your taxable income to £100,000 and get your whole personal allowance back.
Pension contributions can also help families keep their Child Benefit, which they would lose if one partner or parent in the household earns more than £50,000.
For example, someone earning £52,000 would have to repay 20% of any Child Benefit they receive via self-assessment. But if they contributed £2,000 (gross) into a pension, they could retain their full Child Benefit payment and avoid a tax charge.
What’s more, investing into a pension can help higher-earning individuals bring their income below the additional-rate tax threshold of £150,000.
In addition to the 20% basic-rate relief, higher or additional-rate taxpayers can also claim an extra 20% or 25% relief on pension contributions via your annual tax return.
Options for income in retirement
The retirement income you take from a pension is taxable, whereas you can access funds from an ISA anytime without any tax liability.
The tax savings on income taken from ISAs in retirement can be considerable. But, unlike pensions, the money you put into your ISA has had Income Tax applied before you invest it.
You can take 25% of your pension fund tax-free. Using that carefully together with the personal allowance means you can take pension income tax-efficiently.
Pensioners typically pay lower Income Tax rates than they did while they were working. This means that, for the vast majority, the tax relief gained when putting money into a pension is more than the tax rate on the money taken out.
But using your pension together with ISA income gives you even more tax-planning options.
One more consideration is that most pensions are not subject to Inheritance Tax when you die. ISAs are subject to IHT, except when left to spouses or civil partners. So, you’ll need to think about whether you want to prioritise income from your ISA savings to leave more of your pension benefits intact for beneficiaries when you die.
The 2021 Budgets sent a clear message that effective tax planning by using pensions and ISAs together is increasingly important for all savers – not just those affected by the lifetime allowance.
For individuals, it’s wise to make full use of the allowances you’re entitled to, to ensure you pay the appropriate amount of tax – not too much, not too little – while families should pool their resources to get the maximum value from their wealth.
The last few weeks of this tax year, and the beginning of the next one, provide immediate opportunities to help shore up your financial wellbeing. So get in touch for more advice.
The value of an investment with St. James's Place will link directly to the performance of the funds selected and may fall as well as rise. You may get back less than the amount invested.
The tax levels and reliefs can change at any time and depend on individual circumstances.
1,2 Overview of the October 2021 economic and fiscal outlook, Office for Budget Responsibility, October 2021
3 Commentary for annual savings statistics, Gov.uk, June 2021