Could your clients use a pension to offset ISA losses?

29 July 2020

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Craig Muir, our Senior Pension Development and Technical Manager, looks at an ISA/pension case study that focuses on offsetting potential losses clients may have suffered.

We live in unprecedented times - I’m not sure how many times you’ll have heard and read this recently (the first time I heard this I thought the speaker was talking about the American people and Mr Trump, who as I write this is suggesting UV light and disinfectant to kill COVID-19!) but here’s a suggestion which you can use to boost client’s assets at any time.

Case study

Let's consider a client who has money in an ISA and how they can increase their assets by switching it to their pension.  

Meet Graham

In April 2019:

  • Graham was aged 55
  • he was employed, had a pension fund of £400,000 and was a higher rate tax payer
  • he put £20,000 into a balanced portfolio with his ISA provider.

By April 2020, Graham's ISA portfolio had dropped 20% from the original value and was valued at £16,000. He knows that portfolio values can fluctuate, but is concerned he needs 25% growth to recover his loss.

Over the next five years, Graham's balanced portfolio performs well and returns 31.25%, bringing his fund up to £21,000. However, based on his initial investment of £20,000, this is a compound annualised return (CAR) of just 0.82%.

So what could Graham have done differently?

Graham understands how pension tax relief works and knows that regardless if you’re a non-taxpayer, basic, higher or additional rate tax payer, if you pay into a relief at source personal pension scheme, the pension provider will provide basic rate tax relief. If you’re a higher or additional rate tax payer, you can claim back extra tax relief from HMRC.

So although the ISA value had dropped to £16,000 in April 2020, if Graham had switched it to his pension, then assuming he still had available annual allowance, this would have attracted 20% tax relief - bringing it back up to his initial investment of £20,000.

As Graham is a higher rate tax payer, he knows he can claim the additional tax relief from HMRC, but decides he would rather boost his pension savings.

He works out that a gross contribution of £26,667 would produce a net contribution of £16,000 after 40% tax. As the pension provider only applies basic rate tax relief at 20%, Graham realises he would need to pay a net contribution of £21,333 for a gross pension amount of £26,667.

If Graham had an additional £5,333 on deposit and he paid this in at the same time as the £16,000 from his ISA, his gross pension contribution would have increased to £26,667.

As a higher rate tax payer, Graham would claim the £5,333 back from HMRC to replace the money he had on deposit.

So instead of having £16,000 in his ISA, he has £26,667 in his pension. An increase from his initial investment of 33% and 67% higher than what he would have had in his ISA.

Assuming the charges are the same and Graham invests in a similar balanced portfolio and receives 31.25% return over the next 5 years, his pension would be worth £35,000, an annualised growth rate of 9.78% of the initial ISA investment, compared to 0.82% in the ISA.

Great, but the ISA would provide £21,000 tax free and of course, the pension will be taxed at Graham’s marginal rate, so what would the net income be:

Perhaps at age 61 Graham will be a basic rate tax payer, but even if he’s still a higher rate tax payer, he would receive £24,500 net instead of £21,000 from his ISA.

Other things to consider 

As an adviser, there are other things to consider. For example, the impact of the money purchase annual allowance if Graham took his pension savings as a lump sum and of course, death benefits.

If Graham died at age 61 and his estate was in excess of the nil rate band, his £21,000 ISA would be subject to 40% inheritance tax, but the personal pension of £35,000 would be paid tax free to his beneficiaries.

Of course, you'll need to consider your client’s personal circumstances and objectives, and a combination of tax wrappers will likely provide the most tax efficient income in retirement.

However, the tax relief granted to pension contributions could help to alleviate some of the losses from other investments. We can’t change past performance, but using a different tax wrapper could improve the chance of better performance in the future. 

About the author

Craig Muir

Senior Pension Development & Technical Manager

Craig joined the Life & Pensions industry straight from university in 1988, putting his degree in Biological Sciences to great use by joining Scottish Widows before moving to Royal London. He has held several roles, including proposition training and development officer for Royal London before finally putting his analyst degree to use when he moved to Marketing in 1997 where he specialised in market research and analysis. Craig became Chairman of LAMRA, an informal association of Life Assurance providers, in 2004 as he worked to improve marketing and market research standards within the Financial Services Industry. Taking up a new role as an Intermediary Development & Technical Manager at the start of 2011, Craig is a specialist in interpreting and explaining changes to the pension rules and regulation. Craig is involved in developing adviser facing content, presenting, writing articles and commenting for the press. Craig is an avid rugby fan and continues to follow the lows and lows of Scottish rugby.

This website is intended for financial advisers only and shouldn't be relied upon by any other person. If you are not an adviser please visit royallondon.com.

The Royal London Mutual Insurance Society Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The firm is on the Financial Services Register, registration number 117672. It provides life assurance and pensions. Registered in England and Wales number 99064. Registered office: 55 Gracechurch Street, London, EC3V 0RL.