Additional Voluntary Contributions vs Investing After Tax


(Jeff puckering) #1

More of a question about tax as I have been wrestling with the pros and cons of AVCs to my work pension vs investing myself in an ISA (a la freetrade). Not something thing I need to know for a little while but in the next 6 months or so I should have a bit of spare cash each month and have been trying to figure out the variables I need to consider.

Situation:

  • 30 years of contributions left
  • higher tax band
  • maxed out employer contributions to pension
  • highly likely to hit maximum lifetime allowance with just the work pension
  • work pension fund options are fairly safe set of L&G type funds with a few that are majority globally diversified stocks and shares

I think the crux of it is understanding if, once you know your going to be over your lifetime allowance do the benefits of AVCs become redundant as your going to get taxed as much as you would in your pay when you retire, and do you think the growth you would get outside the work fund will make up for the tax and fund charges.

Is there more to it than this or am I trying to over complicate it?

Asking for a friend :eyes:


(Harry) #2

If you’re genuinely projected to go over the Lifetime Allowance then ISA would look like the better decision. Excess of LTA taxed at 55% if taken as lump sum, or 25% if taken as income (plus income tax so could be 25% punitive charge + 45% income tax if you’re a big earner in retirement).

Max funding your ISA would be a good shout in my opinion, £20k tax free :slight_smile:


(Martin) #3

Hi guys

I am no expert at all with regards to pension contributions vs ISA share buying etc, BUT would it not always be more beneficial to invest in an investment isa over a pension assuming they both have a similar performance over the 20 or 30 year period etc?

Especially if you are getting dividends and then reinvesting them into the same company?

Thanks


(Harry) #4

Hi Martin :slight_smile:

What is your thinking for it to be better for an ISA?

Certainly, once invested there is no difference to the investment as both receive beneficial tax-free growth.

Pros of a pension: you can potential invest more per year (40k vs 20k in an ISA, but this can reduce to £10k pa for a pension depending on your earnings), and your contributions are ‘grossed up’ when contributing to a pension I.e if you pay £100 into your pension you end up investing £125 (as long as it’s within your annual allowance)

Drawback: you pay income tax on the way out at the other end. With an ISA you pay not tax at the end.

It’s a good debate though as there are lots of technicalities and different views - I’m interested to hear yours :slight_smile:


(Alex Sherwood) #5

I’d be interested to hear more about this - where does the extra £25 come from exactly?


(Harry) #6

So it depends on how your pension is paid into, but you get tax relief on the way in and taxed on the way out.

If your employer pays your contributions, net pay method, they pay it before income tax. So it isn’t ‘grossed up’ but it isn’t taxed either. I.e if you were paid £100 and are taxed at 20% income tax rate you would receive £80 net, so you would be contributing £80 to your pension from your ‘gross’ £100. With net pay your £100 is getting you £100 worth in your pension.

If you contribute to your pension from your savings, relief at source method, i.e. £80 per month, the pension provider requests the additional from HMRC. The concept here is someone has been paid £100, been taxed on it at say 20% (basic rate band) and received £80 net. They contribute this to a pension, the pension provider puts this back to the gross amount of £100 by topping it up by 25% (£80 + 25% = £10, £100 - 20% = £80) and claims this from HMRC.

If you pay higher or additional rate tax (40-45%) you can Calum the rest on your self assessment form, so there’s even more benefit for these higher tax payers.

Does that make sense? :sweat_smile:


(Jim) #7

Your ISA £s can be accessed anytime whereas your pension stash is locked away until you’re at least 55. As ever with ISAs / pensions be aware that the rules can change in the future at the whim of the government of the day…


(Vladislav Kozub) #8

In addition to what @HarryG said, on the proviso that you are NOT hitting the lifetime limit (currently £1.03m but will increase with CPI), SIPP is always more beneficial than ISA if you are a higher rate payer and only contribute the chunk that is taxed at 40% or more and if your employer matches (if you contribute 5%, the employer is obliged to add at least 2% [will be 3% as of April], but they can voluntarily match more). On your way out, you can have 25% of your entire pension tax-free and then it will be taxable at your normal income rate.

If you will only have your pension to sustain your later life, likely you will not be exposed to 40% income tax too often, whereas will still benefit from getting it refunded throughout your career if saving in SIPP.


(Martin) #9

That’s why I was asking the question to hear people opinions.

Apart from the isa cap of 20K which could change as time goes by, I was thinking isa would be better as you get the dividend return which would be compounded if reinvested.

You also have more control over the stock I and when you wanted to switch or sell and buy new stock within the isa.

And the main draw back for me with a pension is you only get 25% lump sum tax free at the moment and then you are taxed, you also only get a monthly payment to last you X amount of years.

And the way things are going the pension age keeps being increased.

From a personal point of view I just prefer to have the control over my own finances instead of other companies/government.

I guess this is a very difficult decision for anyone who is employed and trying to plan for their retirement as supposed to people who maybe have different sources of income streams.

Great points you have pointed out though :+1:


(Harry) #10

You can hold exactly the same holdings in your pension as in your ISA, in fact you can actually hold way more in a SIPP than an ISA and can add leverage which you can’t in an ISA.

You don’t have to buy an annuity at retirement since pension freedoms in 2015. You can keep your pension invested the whole time, or drawdown on it as and when needed. So you aren’t actually limited to a monthly payment :slight_smile:


(Martin) #11

Interesting points Harry.


(Jeff puckering) #12

Thanks for the replies everyone, lots to think about :thinking: one aspect that got me thinking was the impact of compound interest. As @HarryG mentions there is potentialy 40% uplift in the amount you can invest doing it pre taxable salary which if your company has decent partners for investment options would be a mighty advantage even when taking 45% out at the end assuming a drawdown with highest income tax.

Apologies as I’m writing this as I’m thinking it through so Ill do an example to see if what I say makes sense.

Example 1:

  • additional £1000 avc every year (paid 83.33 monthly)
  • assuming that it is all going to be over the lifetime allowance
  • modest 4.5% growth due to fund management charges. - 25 year period
  • 45% taken off the final value for tax (although there would be additional growth with a drawdown, I am ignoring this for now).

Example 2:

  • additional £600 (the £1000 taxed at 40%) every year into an isa (£50 monthly).
  • Modest but higher growth as no management charges with freetrade 5%
  • 25 year period.
  • No tax at the end

My calculations come to a pot at the end of:

Example 1: £30,065

Example 2: £29,899

:tired_face: too close to count! With the uncertainty of gov policy it feels like ISA is the less risky strategy :thinking:


(Vladislav Kozub) #13

I am slightly lost with you numbers Jeff, but the key point of a pension is that it disincentivises going beyond the lifetime limit. If you anticipate getting there at some point - you need to slow down/stop contributing and switching to ISA.

You forgot your employer’s contributions on the top of that. Minimum is 3% (as of next April) on your total salary if you contribute 5%. If £1000 you are referring to is 5% of your salary, your total contribution will be £1,600. If you did not contribute into a pension, you would have ended up with £600 on your payslip. Therefore, here is 160% growth in one day.

If you keep it with Freetrade, you can mirror your GIA/ISA investment allocation with shares and ETFs, no necessity for fund managers, so keep it as 5%.

Over-the-limit withdrawal results in a 55% tax if taken as a lump sum or 25% if drawn as an annuity. If you are referring to the additional income tax rate, which applies on over £150,000 income, it will unlikely come from your pension, as you would have run out of your pot by the age of 65 :sweat_smile:


Your adjusted figures (both based on 5%, ISA at £50 monthly and SIPP at £133 monthly), I think, will be the following:

SIPP: ~£80,000
ISA: ~£30,000

SIPP will always be more efficient if you are on a higher or additional tax band, regardless of your circumstances (unless you are getting close to the limit or may need the money before the age of 57, which ISA allows for).


(Martin) #14

What a fantastic reply.

I have been looking at potentially investing in a SIPP and an ISA but it’s a bit complicated trying to decide what’s better for me, the downside is the length of time we have to wait to access the pension which could change if the government decide.

But the potential gains that can be made due to the uplift in contributions is appealing.

I am struggling to decide to be honest


(Jeff puckering) #15

Thanks @Vlad I haven’t made a couple of additional assumptions that I stated in the intro explicit again which should clear up some of your queries:

As the thread title suggests I am ringfencing only the avc portion of the pension vs an ISA, as you rightly point out company contribution beats everything, so trying to compare what to do with spare cash once you have maxed your employer contributions with the assumption that the base pension is forecast to reach the lifetime allowance.

I’m reducing the growth assumption for avc’s as they will be restricted to the funds that the employer offers which will likely be with traditional companies and in my experience range from 0.2% to 0.7% charges.

Yes this is what I am referring to, but I didn’t realise it was £150,000 so your right I can reduce that, I guess the assumption I would want to make is that the core pension that had reached the lifetime allowance will result in an income that will be in the higher 40% tax band rather than 45. Meaning the avc’s we have ringfenced in this example to be taxed at the higher income rate of 40% rather than 45%.

With the new numbers I would expect the avc option to come out slightly more ahead :thinking: I’ll have to do he calculations again and edit my assumptions in the previous comment.

Apologies if I have still missed out something significant! I started thinking about this at 7 this morning when my son woke me up!


(Vladislav Kozub) #16

Remember you are only taxed 40% on the incrememtal income beyond £46,350 (at the moment). Plus you have your allowance of £11,750 annually. Plust you have 25% lump sum tax free as well.

All these factors will make SIPP more appealing.

And the government needs to wake up one day and allow free pension transfers even during your employment. Currently you can switch from your employers’ pension providers to a SIPP once you leave, but that is not convenient. It must always be flexible and I wonder when tories are going to action on it :sweat:


(Harry) #17

You can transfer your pension anytime - if it is your employer scheme you can opt out and transfer it. Some schemes have an exit penalty but otherwise there isn’t a flat charge for transferring. Is this what you mean or have I got the wrong end of the pension-stick?


(Jeff puckering) #18

Apologies @Vlad I am so focused on answering the avc vs isa question I’m not really listening to the SIPP point you keep making. Although I knew there were some tax benefits I naively put SIPP in he same bracket as an ISA, But have now looked it up and your right there is no competition, it would seem if your happy tying it up till the age of 55 avc’s seem redundant. The advantage with the ISA is purely flexibility if you want to retire pre 55…

Thanks for cutting through the noise @Vlad!


(Jeff puckering) #19

I think the crux is that if you want the employer contributions it’s stuck in the employer controlled funds. so even though your right you can technically opt out then move the funds but you never would as the employer contributions are too valuable.

I think what @Vlad is saying is that it would be better for you to be able to take the employer contributions into your own SIPP from the moment they give them too you.