Q. My burning question of the day is whether to put more money into a pension fund or whether to invest in some other way. I know that under the new rules I could put more than I currently do into the pension and I can afford to do so. However, could the money be put to better use elsewhere or should I make the most of the maximum allowed limit for pension investment before the new tax rules kick in.
I suppose the question I am asking is what return would we need to get from alternative investments to match the return from a pension after tax benefits are taken into account?
A. That’s a great question. In fact, I’ve just seen a new client this week in a similar position. I’ll do my best to answer it, but do bear in mind that the answer could differ the more information I have about your circumstances.
Many people invest money into pensions simply because of the tax breaks. Keep in mind that a pension is simply a tax wrapper, and not an investment. If you’re investing into a private pension the KEY is to choose your asset allocation wisely (the split between cash, bonds, property and shares). This is normally linked closely to your risk profile.
The first step to take is to calculate how much money you’ll need when you retire. Now, keep in mind that retirement is different for many people. Some want to stop work overnight, whereas some want to ‘slow down’ over a period of time. You should complete a spending plan and calculate how much money you may need in retirement.
Once you’ve done this, you need to work out how far all your existing arrangements will go towards hitting the income target. Remember to use the after tax income from pensions, including any state pension.
Once you know this, you’re in a position to take action, if required. If you DO need to invest more towards the future, you should be able to work out if you should use pensions or ISAs (for example). And remember, the asset allocation should be the same, regardless of which tax wrapper you choose.
The merits of pensions vs ISAs are usually dependent on how you want to take the income in retirement. With pensions, you’ll get the tax relief now on contributions, but 75% of the pension fund in retirement will be taxable (usually). With ISAs you get no tax relief up front, but you have access to all the money at any time.
To answer your last question, if you’re a higher rate taxpayer you’ll get £67 of tax relief for every £100 of your money invested (67% return), and £28 as a basic rate taxpayer. So, as you can see you can achieve fantastic immediate returns.
To match the return on a pension, as a basic rate taxpayer you’ll need to get about 10% pa return on an ISA if the pension was getting 7% pa return. As a higher rate taxpayer, you’ll need to get about 13% pa return.
I hope this helps answer your questions.
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About Ray Prince
