Using a pension to offset ISA losses
Usually, investment losses can be offset against gains made on other holdings. But assets held in ISAs are not subject to capital gains tax, which means losses can’t be offset against anything else. Or can they?
Let's consider Graham, who has money in an ISA. We’ll look at how he can increase the value of his assets by switching it to his pension.
In April 2021:
- Graham was aged 55.
- He lives in England and is an English taxpayer
- He was employed, had a pension fund of £400,000 and was a higher rate taxpayer.
- He put £20,000 into a balanced portfolio with his ISA provider.
- By April 2022, 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 (£16,000 x 1.25 = £20,000).
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%.
How does the tax treatment of contributions to an ISA compare to a pension?
Graham understands how pension tax relief works and knows that regardless of whether someone’s a basic, higher, or additional rate taxpayer, paying into a relief at source personal pension scheme means the pension provider will provide basic rate tax relief. Higher or additional rate taxpayers can claim back extra tax relief from HMRC.
So, although the ISA value had dropped to £16,000 in April 2022, if Graham had switched it to his pension, and assuming he still had available annual allowance, he will automatically receive 20% tax relief, which brings it back up to his initial investment of £20,000.
As a higher rate taxpayer, Graham knows he can claim the additional tax relief from HMRC but decides he’d rather boost his pension savings.
He works out that a gross contribution of £26,667 would give a net contribution of £16,000 after 40% tax. As the pension provider only applies basic rate tax relief at 20%, Graham realises he needs to pay a net contribution of £21,333 for a gross pension amount of £26,667.
If Graham has £5,333 in savings elsewhere, and he pays 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 taxpayer, Graham can claim the £5,333 back from HMRC to replace his savings.
So instead of having £16,000 in his ISA, he now 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, Graham invests in a similar balanced portfolio and receives 31.25% return over the next 5 years, his pension would be worth £35,000. This gives an annualised growth rate of 9.78% of the initial ISA investment, compared to 0.82% in the ISA.
Great, but the ISA would give £21,000 tax free and of course, the pension will be taxed at Graham’s marginal rate, so what would the net income be:
|Basic rate tax||Higher rate tax||Additional rate tax|
|Tax-free cash - £8,750||Tax-free cash - £8,750||Tax-free cash - £8,750|
|Net pension - £21,000||Net pension - £15,750||Net pension - £14,437|
|Total - £29,750||Total - £24,500||Total - £23,187|
|6.84% CAR||3.44% CAR||2.50% CAR|
The above figures assume that his personal allowance is used up by other income he receives.
Perhaps at age 61 Graham will be a basic rate taxpayer, but even if he’s still a higher rate taxpayer, he would receive £24,500 net instead of £21,000 from his ISA.
How does the IHT treatment of a pension compare to an ISA?
If Graham takes his pension savings as a lump sum, this will of course trigger the money purchase annual allowance.
And then there’s the death benefits to think about. If Graham died at age 61 and his estate was more than the nil rate band, his £21,000 ISA would be subject to 40% inheritance tax, but his personal pension of £35,000 would be paid tax free to his beneficiaries.
The value of the ISA would be available as an additional permitted subscription to Graham’s spouse or civil partner’s own ISA. This is in addition to their own annual personal ISA subscription amount.
Of course, the individual’s personal circumstances and objectives need to be considered, 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.
Things to consider
- Regardless of whether someone’s a basic, higher, or additional rate taxpayer, paying into a relief at source personal pension scheme means the pension provider will provide basic rate tax relief.
- Taking pension savings as a lump sum, will trigger the money purchase annual allowance.
The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice. Also it may not reflect the options available under a specific product which may not be as wide as legislations and regulations allow.
All references to taxation are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.
Where to next...
Pension contributions - all you need to know
This analysis focuses on pension contributions, who can pay them and if there are any restrictions.
Money purchase annual allowance – case studies
Accessing flexible benefits will result in triggering the money purchase annual allowance but how does it work in practice?