A pension is vital. The state pension is hardly generous, even for a couple, and doesn’t kick in until the late 60s. A pension means you can live better and you can retire earlier than state pension age. As we will see later, that pension can be held in a pension account or in an ISA.
Why use a pension rather than an ISA?
• Your employer might be contributing heavily to your pension. This free money is incredibly important, and rarely to be declined. Currently I contribute 6% and my employer contributes 10%. I consider that 10% to be like a guaranteed bonus and a part of my pay package.
• Then there’s a tax reason. Many people move to a lower marginal tax rate when they draw a pension, rather than having a full-time job. This is enhanced because pension income has no NI charges.
So for example, you might earn now with a 42% marginal rate (tax plus NI), but in retirement your marginal rate is 20%. For people like me who should stay a little under the Lifetime Allowance, it seems possible to stay at the 20% rate in retirement if we plan carefully, assuming conservative growth. (With high growth the nice problem of paying 40% tax on SOME of the pension appears, and/or leaving some money in drawdown when I die.)
In your early 50’s this tax reason can be really important. If we have a few thousand spare, it’s going into my or my wife’s SIPP rather than pay off the mortgage – I’ll pay that off when the tax-free pension cash lands in my current account at age 55. (There’s reasons for using my SIPP and other reasons for using my wife’s SIPP instead. For a rarely mentioned reason, see Pension page “6 – Model” section “Improvement 1”.)
• Related to that, if you pay 20% tax then you probably pay 32% including NI. In retirement you might pay 0% or 20% on pension income but no NI.
• Student loan 9% and child benefit taper mean that at times your marginal rate could be far higher than 42% (40%+2%). You might want to make extra AVC or SIPP contributions at that time.
• Some pension (often 25% of it) is available tax free from age 55. (See the page on drawdown)
• Without employer contributions or these tax differences, the mathematical advantage of a pension disappears. The non-mathematical reason to have a pension is that some people find it good to have the pension locked away so there’s no temptation to spend it.
On the other hand…
• A few years ago, my wife and I had built up a reasonable ISA intending to clear the interest-only mortgage. But then we decided that by renegotiating timings with our building society we could use some of it on a few years of kids’ education costs. If we’d had it in a pension, we wouldn’t have had the choice. OK, our ISA wasn’t set up as an alternative to a pension, but the point is that an ISA offers choice.
• If you exceed your lifetime allowance you might wish you’d put your excess money in your spouse’s pension or in an ISA instead. (There’s a separate page on the impact of the LTA).
