The recent budget announcement has certainly stirred up a lot of discussions, especially with the news that pensions will fall into the inheritance tax (IHT) net from April 2027. This change has led many to question whether contributing to pensions is still worthwhile. However, despite the new IHT rules, pensions remain a valuable tool for retirement savings.
Pensions vs ISAs: a comparative analysis
When comparing pensions to Individual Savings Accounts (ISAs), it’s important to consider several factors: tax relief on payments in and out, tax while invested, and tax on death.
Tax relief on payments:
- Pensions: Contributions to pensions benefit from tax relief at your highest marginal rate. For example:
- If you’re a higher rate taxpayer (40%), for every £20,000 you contribute, the Government adds £13,333.33, making it £33,333.33 in your pension pot.
- ISA: Contributions to ISAs do not receive upfront tax relief. So, if you invest £20,000 in an ISA, only £20,000 is invested.
Tax while invested:
- Pensions: The investment growth within a pension is tax-free.
- ISAs: Similarly, the growth within an ISA is also tax-free.
Inheritance Tax position
- Pensions: From April 2027, most unused pension funds will be included in the estate for IHT purposes. If your estate exceeds the IHT threshold (£325,000, rising to £500,000 if your home is passed to direct descendants), the excess may be taxed at 40%.
- ISAs: ISAs are also subject to IHT. The value of your ISA will be included in your estate and may be subject to the 40% IHT if your estate exceeds the threshold.
Tax beneficiaries pay on the net estate
- Let’s assume £20,000 is paid into an ISA and £20,000 is paid into a pension by a higher rate taxpayer (40%). We assume no growth and the individual dies after age 75 before withdrawing any money. The estate is subject to IHT and the beneficiary is a basic rate taxpayer (20%) or a higher rate taxpayer (40%).
- ISA: The £20,000 in the ISA is included in the estate. If the estate exceeds the IHT threshold, 40% IHT is applied: IHT on £20,000: £20,000 x 40% = £8,000. Therefore, the amount left for the beneficiary: £20,000 – £8,000 = £12,000
- Pension (basic rate beneficiary): The £20,000 pension contribution benefits from 40% tax relief, making it £33,333.33 in the pension pot. The £33,333.33 in the pension pot is included in the estate and subject to IHT: IHT on £33,333.33: £33,333.33 x 40% = £13,333.33 Amount after IHT: £33,333.33 – £13,333.33 = £20,000. As the individual dies after age 75, the beneficiary pays income tax on withdrawals at their marginal rate (20%). Income tax on £20,000: £20,000 x 20% = £4,000. The amount left for the beneficiary: £20,000 – £4,000 = £16,000, which is more than the ISA.
- Pension (higher rate beneficiary): The amount after IHT is the same as the example above. £33,333.33 – £13,333.33 = £20,000. As the individual dies after age 75, the beneficiary pays income tax on withdrawals at their marginal rate (40%). Income tax on £20,000: £20,000 x 40% = £8,000. The amount left for the beneficiary: £20,000 – £8,000 = £12,000, which is the same as the ISA.
| Scenario £20,000 investment | Initial amount | IHT (40%) | Amount after IHT | Income Tax rate | Income Tax | Net amount for beneficiary |
| ISA | £20,000 | £8,000 | £12,000 | N/A | N/A | £12,000 |
| Pension (basic rate beneficiary) | £33,333 | £13,333 | £20,000 | 20% | £4,000 | £16,000 |
| Pension (higher rate beneficiary) | £33,333 | £13,333 | £20,000 | 40% | £8,000 | £12,000 |
Why pensions are still worth it
Despite the new IHT rules, pensions offer several advantages:
1. Tax relief: The upfront tax relief on contributions can significantly boost your retirement savings.
2. Employer contributions: Many employers offer matching contributions, which can further enhance your pension pot.
3. Flexibility: Pensions offer various options for accessing your funds in retirement, including lump sums and income drawdown.
4. Higher contribution limits: Unlike ISAs, which have an annual contribution limit of £20,000, pensions often allow for higher contributions, enabling you to build a more substantial retirement fund.
Comment
While the new IHT rules may seem daunting, pensions remain a powerful tool for retirement planning. It’s essential to weigh the benefits of tax relief and employer contributions against the potential IHT liability. Consulting with a financial adviser can help you navigate these changes and make informed decisions about your retirement savings.
How can we help?
Zoe Till is a Partner and Chartered Financial Planner in our expert Independent financial advisers team. Zoe’s areas of expertise include investment advice, retirement planning, IHT and lifetime cash flow modelling.
If you would like any advice concerning the subjects discussed in this article, please get in touch with Zoe or another member of the team in Derby, Leicester, or Nottingham on 0800 024 1976 or via our online form.
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