Use your Isa to dodge 55pc tax on pension withdrawals – Telegraph.co.uk
Dear Kate,
My pension fund is edging closer to the lifetime allowance, which I know is frozen until 2026. I want to maximise my retirement income by using a combination of pensions and Isas.
I’m thinking about increasing my contributions into my Isa and reducing or potentially stopping my pension contributions to avoid breaching the lifetime allowance, which I know can result in a 55pc charge on pension withdrawls. Does this make financial sense? I’m 52 and not planning to access my pension for at least another 10 years, although I will probably access my Isa earlier.
Anon, via email
Kate says:
Over the last 10 years, the amount which can be paid into a pension each year with tax relief, and the overall maximum that can be held without suffering a tax charge, have become less generous. Over a similar time period, we’ve seen increases to the Isa allowance. Together this has meant more people are using Isas to help them fund their retirement. A combination of having pensions and Isas gives people more choice and flexibility.
One specific group are those affected or potentially affected by the frozen pension lifetime allowance of £1,073,100 until April 5 2026. For them, Isas have become more attractive as part of their retirement planning.
Finding a winning formula
Having an Isa and a pension can be a winning formula. It’s a good idea to have both to give you more options, helping retirement and tax planning. The main difference between pensions and Isas is their tax treatment.
Pensions are the most tax-efficient way of saving for retirement with tax relief on personal contributions equal to the top rate of income tax you pay. For additional-rate taxpayers, that’s 45pc (46pc for Scottish taxpayers). When you factor in employer contributions, and that many employers contribute more than the statutory 3pc auto-enrolment contribution, and may go further by matching employees’ contributions, saving in a pension seems like a no brainer.
However, for some, the attraction of continuing to contribute to a pension may diminish as pension savings get close to, or above, the lifetime allowance. Funds above that allowance face additional taxes when taken.
Isas are also tax-efficient savings and can be used to provide an income in retirement. Contributions are paid from taxed income, so are ‘taxed’ on the way in. A major attraction of Isas is that payments out are tax-free which can be useful for income tax planning. For pensions, apart from the 25pc tax-free cash sum, the rest is taxed at your marginal income tax rate.
Money held inside an Isa isn’t subject to income or capital gains tax, just like pensions.
Isas tend to be more flexible than pensions, as you have the freedom and flexibility to access them whenever you want. Pensions can currently only be accessed from age 55, although this age will increase to age 57 from 2028, making the flexibility of Isas a bit more attractive. However, you need to watch out for early withdrawal penalties, for example, on fixed-term cash Isas. Early access means that Isas can be useful for providing an income if you retire early or need to supplement part-time work as you approach retirement.
Lifetime Isas (Lisas) are a particular type of Isa which have been designed to fund retirement (as well as to buy your first home). But they aren’t available to the over 40s such as yourself, as you have to open a Lisa before your 40th birthday. Then it’s possible to save up to £4,000 a year until your 50th birthday and the government will add a 25pc bonus to these contributions, up to £1,000 a year.
The Lisa limit of £4,000 counts towards your £20,000 annual Isa limit. Lisas aren’t as flexible as other Isas as a hefty 25pc penalty applies on any funds withdrawn before your 60th birthday (unless used to buy your first home or you are terminally ill).
Navigating the lifetime and annual allowances
Having a combination of pensions and Isas allows you to navigate the pensions annual and lifetime allowances.
The annual allowance is the total amount of contributions that can be paid to a pension in a tax year while still benefiting from tax relief, up to £40,000 a year (although this can be lower for high earners or those that have flexibly accessed their pension already). You can pay up to £20,000 a year into an Isa from taxed income, regardless of how much you earn.
The lifetime allowance limits the value of pension benefits that can be taken from all your registered pension schemes, whether it’s a lump sum or retirement income, without triggering a tax charge. The good news is that there’s no lifetime limit on the amount you can hold in an Isa.
If you are concerned about breaching the lifetime allowance, you could consider diverting some or all of your pension contributions or other savings into Isas. A word of warning – stopping your own pension contribution could mean that you lose your employer’s pension contribution. An alternative may be if you’re paying high pension contributions is to reduce these to the level where you still receive your employer’s contribution. Then pay the difference into your Isa.
Cash versus stocks and shares Isas
Despite interest rates gradually increasing, interest rates on cash Isas are low and are highly unlikely to keep up with the high inflation rates we’re currently experiencing. This means that cash funds are likely to lose value in real terms, which could be significant over time, so aren’t best suited to fund a retirement income.
An alternative is to invest in a stocks and shares Isa which is suitable for medium to longer term (that is, five years plus) savings. These offer a wide range of investments, similar to those offered by pensions, and allow funds to grow tax-free, with the potential to outperform inflation.
Pensions doctor Kate Smith, of pension firm Aegon, solves your retirement issues. Write to Kate with your pension problem via pensionsdoctor@telegraph.co.uk. Columns are published twice a month on Tuesday mornings
