Could an ISA taste nicer if you SIPP it?
Following the publishing of the Government’s landmark pension reform Bill in the House of Commons last week, Mr. Osborne said, “People who have worked and saved all their lives will be able to access as much or as little of their defined contribution pension as they want from next year and pass on their hard-earned pensions to their families tax free.”
The scrapping of the 55% death benefit charge on pensions in drawdown is the final piece of the retirement savings jigsaw. It now provides clarity on the best place to save, the best place to take cash from, and how to maximise what’s left behind for future generations.
These changes, however, are raising a new set of questions. Do we carry on in the age old tradition of using pension funds to meet all our retirement income needs? Do we now consider taking income from other investments such as ISA first? Or given the improved inheritability of pensions, do we now consider transferring ISA savings and generate our retirement income entirely from our pensions?
ISA and pensions working together
For those who have saved in both ISAs and pensions and are thinking about how they’ll provide for their loved ones, the changes to the treatment of death benefits beg two main questions:
- Should a retirement income be drawn from ISAs or pensions first?
- Is it tax efficient to transfer between ISAs and pensions?
Both questions can be answered by looking at the potential taxes suffered on death.
An ISA is included in the value of your estate and will potentially be subject to inheritance tax (IHT) if the total value of the estate is over the IHT threshold (£325,000 in 2014/2015). At worst, this will be at 40% on the full value if the underlying investments pass to the beneficiary, then the investments they keep will be subject to ongoing income tax and capital gains tax as appropriate.
A pension, on the other hand, will be free of all taxes for deaths before 75, and taxed at 45% at worst for deaths after 75. But for those beneficiaries who take an income from the pension in instalments, this may be as low as zero for those with unused personal allowance, or 20% if basic rate taxpayers. AND, the investments held within the pension will continue to grow without any further tax.
So in answer to the question Should a retirement income be drawn from ISAs or pensions first? those who are concerned about IHT should consider taking their retirement income from their ISA first and therefore reducing their taxable estate.
Is it tax efficient to transfer between ISAs and pensions?
But what about moving the ISA into a pension if you are close to or over 55?
By 55, both pensions and ISAs will be accessible in a similar way, in that there are no limits on what can be taken and when. And, as we’ve already demonstrated, the pension in most cases will provide more spendable income thanks to the tax relief on contributions and the ability to take 25% of the fund tax free. So a transfer from ISA to pension has its merits.
But what about the situation on death? Again, the ISA could be subject to 40% IHT on death. But if you transfer it into your pension, there will be no tax on death benefits before 75. After 75, as long as when the beneficiary takes payments their income tax rate is below 40%, they’ll still be better off.
This is perhaps best demonstrated by a simple example.
Mike is age 55, with £100,000 of ISA savings and a pension pot of £250,000. The rest of his estate is valued at over the IHT nil rate band. He’s been a higher rate taxpayer for a number of years. Sadly, he passes away. His pension would be paid out tax free, but the ISA would suffer £40,000 IHT. The beneficiaries would receive total net proceeds of £310,000.
But if Mike had transferred his ISA into his pension, either in a one off payment (providing he had sufficient earnings and annual allowance carried forward), or perhaps in instalments over 5 years from age 50, ignoring growth his pension would be boosted by £125,000. He would also make a saving of £25,000 on his income tax bill. Now on death at age 55, his beneficiaries would have access to net funds of £375,000. And if the income tax reduction was also saved, this could be over £400,000. Providing up to an extra £90,000.
So in answer to the question Is it tax efficient to transfer between ISAs and pensions? this makes for a compelling argument for moving ISAs into pensions for anyone looking to preserve as much of their savings as possible for their loved ones. Nonetheless, ISAs continue to have an important place in providing easy access funds before the age of 55.
Swindells Financial Planning provides clients with individual, independent and impartial advice. To help you make the right decisions for your retirement, we are holding two seminars on 13th November at Uckfield: Inheritance Tax Planning at 10:30am and Retirement Planning and the New Pension Landscape at 5:30pm.