- October 3, 2023
- Posted by: legaleseblogger
- Category: Related News
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AI Legalese Decoder: Simplifying the Complexities of Tax Relief Timing
There has been a recent discussion comparing ISAs and pensions, specifically focusing on the timing of tax relief. While the wiki page provides an explanation, many individuals, including myself, found the example provided to be insufficient in conveying the nuances of the topic.
To tackle this issue, I have attempted to present a more mathematical explanation that I personally found more satisfying. However, I still believe that the statement regarding the timing of tax relief in relation to pensions is not entirely accurate.
Before diving into the details, it’s important to note that this post may be quite niche in its content. Most people may not find it relevant or necessary to delve into these complexities, and can simply follow the advice provided on the wiki. However, for those who are curious, please enjoy the following explanation.
Why the timing of tax relief doesnÔÇÖt matter:
To begin, let’s consider a basic rate tax (BRT) scenario. In this case, regardless of the initial value (“x”), the after-tax value will always be x * 0.8.
If there is no growth to consider, the calculations are straightforward. Both ISAs and pensions, regardless of when the tax is applied, will result in a final value of x * 0.8.
*No growth*
ISAs (tax now): x * 0.8
Pensions (tax later): x * 0.8
This conclusion is relatively obvious. However, let’s introduce the factor of growth into the equation.
In scenario one, let’s assume a 10% growth rate without compounding. We can calculate the value at the present moment, multiply it by 1.1 to account for growth, and then adjust for any necessary tax.
*Flat growth*
ISAs (tax now): x * 0.8
Pensions (tax later): x * 0.8 * 1.1
Again, this may not be the main focus of this discussion. Now, let’s move on to compounding growth, with a 10% growth rate per year for 20 years (represented as 10% year n).
To calculate the compounded value, we can multiply the starting value by (1 + the growth rate) as many times as desired.
*Compound growth*
ISAs (tax now): x * 0.8
Pensions (tax later): x * 0.8 * y
Surprisingly, the results are the same! This was an aspect that puzzled me when I initially tried to understand this concept. I believed that compounded growth would favor earlier investments, but the timing of tax relief renders this irrelevant. As long as the tax rate remains consistent throughout, the timing of tax relief does not impact the final outcome.
Why that’s an oversimplification (especially for pensions):
The above explanation holds true under the assumption of a simple 20% tax rate. However, there are a couple of key examples that demonstrate why this statement may not always be accurate:
1. If you are currently paying a higher rate tax (HRT) and anticipate a lower basic rate tax (BRT) in the future.
2. If you qualify for a 25% tax-free allowance on your pension.
To simplify these scenarios:
*HRT now BRT later*
HRT = 0.6
BRT = 0.8
ISAs (tax now): x * HRT
Pensions (tax later): x * BRT * y
*25% tax-free*
BRT = 0.8
After Tax Free BRT (ATFBRT) = 0.25 + (0.75 * 0.8) = 0.85
ISAs (tax now): x * BRT
Pensions (tax later): x * ATFBRT * y
These are the two most common examples and are likely applicable to many individuals. However, there is a third scenario that is relevant to some people, namely withdrawing from a pension below the personal tax allowance. While this may not be feasible when claiming a state pension, those who retire early and solely rely on their pension income during a certain period may benefit from reduced tax burdens.
ISAs (tax now): x * 0.8
Pensions (tax later): x * y
It is important to consider these factors, especially in the context of the pension vs. ISA debate. The statement on the wiki regarding the timing of tax relief oversimplifies the matter by assuming a consistent tax rate of 0.8 for both scenarios. However, it is quite common for the comparison to involve different tax rates, such as 0.8 for ISAs and 0.85 (or even better) for pensions. In these cases, utilizing a pension would be more advantageous.
AI Legalese Decoder: Assisting with Complexities
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I appreciate the effort that went into this, although I think itÔÇÖs unfair to say the wiki doesnÔÇÖt cover this. In the specific link you posted it highlights that the timing of tax relief doesnÔÇÖt matter for basic growth (your first points) but specifically says it does matter when you have different tax brackets and taking into account the allowances (your main closing point).
Hi /u/Ok_West_6958, based on your post the following pages from our wiki may be relevant:
– https://ukpersonal.finance/lisa/
– https://ukpersonal.finance/pensions/
– https://ukpersonal.finance/tax-efficiency-for-high-earners/
____
^(These suggestions are based on keywords, if they missed the mark please report this comment.)
Good post. I (and others) have been downvoted on several occasions for pointing out that you should be in the same position if you use an ISA for 10 years and then move it into a pension as putting it all into a pension now, even when you use the figures to back it up, because some on here are adamant that putting it into a pension sooner means more compounding.
Thanks for this.
IÔÇÖm miles away from pension age and IÔÇÖm simply using pension to keep me out of the dreaded marginal rate. I know I need money for the future but donÔÇÖt know what future tax rules will look like, so save away what I can till I have amassed a significant pot.
All of this post is based on todayÔÇÖs assumptions and whilst thatÔÇÖs the best you can do, IÔÇÖm not betting on the rules being as they are today in 25 years time or whatever.
IÔÇÖve previously used pension to hold onto child benefit and to avoid the HRT bracket, when the numbers made sense to do so.
Maybe one day, income will be sufficient that IÔÇÖm prepared to stomach the additional rate even. Until then, pension is for two reasons: saving for an unknown future set of rules, but _to reduce my net adjusted income_ today.
This is awesome – I’ll have a read later of it thoroughly. I just responded to your comment from last night in my post. Let me know your thoughts.
You admit the calculations are simplistic, which is true because for most people what matters is personal allowance. You’d pay 20% tax on the whole shebang now but only 20% on *some* (possibly none) if you use a pension.
Of course higher/additional rate payers will save a bundle (paying 0-20% later instead of 40-45% now), so it’s hugely worth it for them.
Also salary sacrificing into pension can reduce your taxable income such that you get other benefits (like child benefit or nursery fee help).
Hi!
I was one of the people who replied to the other post you refer to, talking about tax relief timing.
This is a helpful post for those who struggle with the non-intuitive and conceptual point around the timing issue, so thanks for that.
I personally don’t think the Wiki falls short in its explanation. And I also don’t think it’s fair to say that pointing out that there is no compounding/timing benefit with pensions is an oversimplification. It’s a fact. It’s an entirely separate fact from the fact that there are significant benefits associated with pensions (TFLS and marginal tax rates). As long as nobody is claiming they don’t exist, I don’t see a problem there.
But ISAs of course have their own advantages, and each person should weigh up what’s best for them.