When a savings vehicle becomes a political football, it’s time to develop your Plan B.
After years of meddling from successive chancellors, pensions are now in the Premier League.
Remember those heady days before a Lifetime Limit or an annual contributions limit? Not to mention the dreaded ‘annual allowance taper’ that can cut your maximum yearly savings to a mere £10,000. That’ll teach you to earn £150,000 a year, you filthy capitalist…
Tomorrow, assuming no further cabinet reshuffles, the latest chancellor will reveal his first budget. Some are saying it will be radical to mark the first move towards Post Brexit Britain. Others suggest that, with a worldwide pandemic throwing a curve ball of unknowable implications, it may be time for a more prudent, vanilla Finance Act. The removal of higher rate pensions relief has been heavily trailed, proving that pensions remain very much in play in the fiscal version of the Beautiful Game.
What gets forgotten in the rush to squeeze the rich is that pensions are taxed on the way out. In other words, someone who pays higher rate tax today may well have retirement earnings high enough to still be paying higher rate tax after they stop work. The principle is that the scheme should be tax neutral, giving with one hand today on the understanding that tax will be taken at some point in the future. It is therefore grossly unfair to offer only basic rate relief on the way in when being fairly certain that you can confiscate higher rate tax on the way out.
ISAs, on the other hand, are taxed on the way in. You are investing post-tax money in a shelter where it can accumulate tax free. That includes avoiding the dividend tax which now kicks in after a paltry £2,000 per annum. But, when you come to withdraw money from the ISA wrapper, it is gloriously free of government grabbers.
I really like this concept way more than the pensions model. Why? Because a serious investor should expect to achieve compounded returns of 6 or 7% a year which means the overall value of your ISA portfolio should be many times what you first put in. And there’s no upper limit on what you can hold in an ISA.
ISAs were one of the few good things we can credit to Gordon Brown who evolved them from the old Personal Equity Plans back in 1999. The initial annual contribution limit was £7,000 but it now stands at £20,000 per person, so £40,000 a year for a couple. It doesn’t take long for that to build into serious money, especially if it’s properly invested. The problem is, our old friend financial illiteracy means that around half of all ISA plans remain in cash, losing value to inflation in these days of zero and negative interest rates.
If you’d contributed the maximum each year since Prince’s party, you’d have £229,560 in your pot. However, the long bull market since the financial crisis has meant that hundreds of people are now ISA millionaires. A million quid tax free is a much better bet than £1.055 million in a taxable pension.
Of course, comparisons are never this straightforward, especially in the country with the world’s largest tax code. Pensions do allow a 25% tax free lump sum to be extracted, and they can be passed to the next generation tax free if you depart the earthly plain before reaching 75. Given our increasing longevity, that concession may be of limited value as your offspring will pay tax at their marginal rate if you reach 76 before they inherit.
Your accumulated ISA wealth can be passed to your spouse free of Inheritance Tax but not to your kids. Unless you’ve invested in AIM listed shares and held them for two years so they qualify for business property relief. Still with me?
All of this pre-supposes that ISAs do not attract the unwanted attention of future chancellors looking for the next soft target. It would be inconceivable that they would retrospectively decide to tax ISAs all the way back to 1999, wouldn’t it? (Those who have not been following the Loan Charge Action Group should take a naivety pill at this point).
However, we can only act on what is in front of us today. My personal favourite remains the Director’s Pension, also called a SSAS, but that is only available to company owners. If the only pension option is a SIPP, perhaps it’s time to start maxing out your ISA allowance? With the tax year ending soon, a couple could shelter £80,000 in the next 30 days and have a new, flexible, tax-free source of retirement income.
Until next time