ISAs versus Pensions
Although most dentists accept they should save for retirement, it doesn't necessarily mean they should invest in a pension. NHS dentists are fortunate as they qualify for the NHS Pension Superannuation Scheme but for various reasons such as increasing private work, this doesn’t always provide sufficient income at retirement. Stocks and Shares Individual Savings Accounts (ISAs) are often suggested as a useful alternative to pensions but do they offer the same tax advantages?
The big difference between pensions and ISAs is when you get your tax benefit. With a pension, your contributions are grossed up, so if you invest £80 a further £20 is claimed by the pension provider making the total £100 - and for a higher rate tax payer your tax bill is reduced by a further £20 making the net contribution only £60. When you draw your personal pension, although you get a tax free lump sum of 25% you will get taxed on the rest of the income.
With an ISA, you don’t get tax relief on your contributions (ie £100 invested is worth £100) but you can take the income tax free.
All things being equal, it can be argued that this amounts to the same thing. For example, look at the position for a higher rate taxpayer who earns £100 gross (that is, £60 after tax), saves it and gets 7% growth for three years before drawing income at a rate of 5%. Each year's income will be the same, for the ISA and the pension:
ISA: 60% x £100 x 1.07 x 1.07 x 1.07 x 0.05 = £3.68
Pension: £100 x 1.07 x 1.07 x 1.07 x 0.05 x 60% = £3.68
This position though is confused by a number of factors. First of all, you're able to take part of your pension pot (usually up to 25%) as a tax-free lump sum.
Secondly, the above example assumes you will pay the same rate of tax in retirement as you do during your working life. Most people's retirement income is lower than their earnings, which may mean they are taxed at a lower rate. For example, someone currently earning around £70,000 a year could get 40% tax relief on their pension contributions but only pay basic rate tax of 20% once they've retired.
So, if you are a higher rate taxpayer now but expect to be a basic rate taxpayer in retirement and/or you intend to take the maximum tax-free lump sum, the pension route has a significant tax advantage.
Other non tax factors you need to consider are contribution limits which are higher for pensions than for ISAs, charging structures and the flexibility of when you can draw out the money.
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