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Pension vs ISA as an income producer

Author Image Catriona McInally Business Development Manager
6 minutes read
Last updated on 28th May 2020

It’s difficult to talk about any investment without thinking about the significant market falls we’ve seen over recent weeks and months. Many advisers will have spent many hours reassuring clients that we will get through this, and at some stage markets will return to normal. Let’s hope that’s sooner rather than later.

Overview

Many clients affected may be about to, or already drawing an income. Several advisers have said to me over the last few years, especially in the light of pensions freedom, that as a matter of course it often makes more sense to take income from an ISA first rather than from a pension. I set out to prove to myself if this strategy works, and how it might play out for a client using an example case study.

Case study

Let’s take Annie who has the following situation

  • She’s a  65 year old widow
  • She has 2 daughters
  • She has no LTA issues
  • She wants to retain capital but benefit children if possible upon her death
  • Her house and other assets exceed the current IHT threshold, and will do so in the future
  • She needs £1,200 per month net to top up existing income
  • Her proposed withdrawals and other income will see her remain in the basic rate tax band
  • She has £200,000 in a pension fund & £200,000 in an ISA
  • She has taken TFC from her pension already to give to her children to pay deposits on house purchases

So which should she draw on first? Let’s have a look at the situation from both an income and death benefit perspective.

Chart A - Income

Wrapper Withdrawal (£) Tax (£) Net Income (£)
ISA 1,200 0 1,200
Pension 1,500 300 1,200


Chart A - Death benefit

Wrapper Value (£) Tax pre 75 (£)

Tax post 75 (£)

0% / 20% / 40% / 45%

Net benefit (£)
ISA 1,000 400 400 600
Pension 1,000 0 0 / 200 / 400 / 450 1,000 / 800 / 600 / 550


As you can see on chart A, from an income perspective the ISA has the obvious advantage of not needing to take account of income tax to provide Annie with her required income.

From a death benefit perspective the benefits her daughters will receive will depend on whether Annie dies pre or post 75 as explained further below.

The Income Tax position

Chart B displays Annie’s position rolling forward for 20 years, showing the fund values assuming income is taken from the ISA.

Chart B - ISA used for income

ISA used for income

 

 

It’s interesting to note that the overall fund value increases although the ISA fund is exhausted at age 85.

Chart C shows Annie’s position reversed, with income taken from the pension first.  

Chart C - Pension used for income

Pension used for income

 

 

Both charts demonstrate the point that in Annie’s position, taking income from the ISA works much better from an income perspective, because of the tax that has to be paid on the pension income.

Whereas the pension fund would be exhaused by age 80 and the overall fund value is falling.

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The Death Benefit consideration

Now let’s have a look at the death benefit position. The ISA fund value in Annie’s situation is going to suffer IHT upon her death. The pension will be dependent first of all on when Annie dies. Prior to 75 it can all be drawn tax free or in stages by the beneficiary, assuming the scheme allows this. If Annie dies post age 75, it is based upon the marginal tax of the beneficiary drawing the income. They can of course control how much or little (or even none) of the income they draw, again assuming the scheme rules allow this. Inheritance tax is not normally an issue in respect of remaining pension funds upon death, though there are one or two exceptions.

In chart D, the beneficiary is receiving the value at a marginal rate of 20%. As would be expected, drawing the income from the ISA first and leaving as much as possible in the pension wins the day, even post 75 when the pension pot becomes taxable.

Chart D - Combined ISA and Pension death benefit position (20% beneficiary)

Combined ISA and Pension Death benefit position

 

In this example, of course the fund would need to be drawn out in stages, if permittable, as otherwise the value drawn in one go would make the beneficiary an additional rate taxpayer.

In chart E we assume the worst possible scenario in respect of the death benefit beneficiary’s tax status – that they are an additional rate taxpayer already.

Chart E - Combined ISA and Pension death benefit position (45% beneficiary)

Death benefit position 45%

 

 

Clearly the situation is unchanged prior to age 75, but even post age 75 taking income from the ISA first, at the start of Annie’s retirement, gives a better outcome than drawing from the pension first.

So thinking about Annie’s position, it is clear that based upon current rules, taking income from the ISA in the first instance makes good sense. Whether considered from an income tax or death benefit perspective.

Clearly this decision could change based upon individual circumstances – but hopefully this gives a feel for the factors that need to be taken into account.

Other considerations

We should also not forget that the normal risks and considerations need to be taken into account by the adviser wherever the income is drawn from.

These are discussed in more detail elsewhere but include:

  • Sequencing of return risk. There are several methods for dealing with this but the adviser should address these at outset
  • The income level should be ‘stress tested’ This could be by both assuming a lower level of return than in the main cashflow modelling undertaken, and also by assuming say a large fall in fund value in the early years. Recent events have shown the wisdom of this!
  • Income drawn should take account of the overall client financial position, including  income from elsewhere and other assets that are available to draw income from
  • The client's attitude to investment risk, inflation risk, capacity for loss and longevity risk must all be considered

Our new online ISA service offers enhanced functionality that’ll make it easier to set up and give you more visibility and control of your clients’ investment, and also allows access to the PruFund range of funds together with the opportunity to draw income.

To find out more about the Prudential ISA or to access the new online ISA service visit  https://www.pruadviser.co.uk/knowledge-literature/isa-online/

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