As financial planners that specialise in working with contractors, one of the most frequent questions we get asked about, is the best way to save for the long term. This was very clearly illustrated at one of the finance seminars we ran last year in London.

As financial planners that specialise in working with contractors, one of the most frequent questions we get asked about, is the best way to save for the long term. This was very clearly illustrated at one of the finance seminars we ran last year in London. After fending off some searching questions on all matters tax and investing, I was ready to relax at the bar. Or so I thought. As I packed away my material, a question is posed to me. “So if I had say £750 per month to invest long term for my retirement, should I put this into a pension or an Equity ISA?” I wouldn’t have minded so much, but it was Iain McIlwee, Head of Commercial Development at PCG, who posed the question. I gave my best politician’s answer, “Well it all depends really.” Obviously, not a satisfactory answer. As I pondered the question more thoroughly, I realised that it would make a good article. So here goes…

There are definitely two tax efficient ways to invest for the longer term, pensions and ISAs. Of course, there are other ways to invest for the future, such as Buy to Let Property. However, to keep focused, we shall ignore these other options today. The annual allowance rules are as follows:

The actual amount that can be paid into a pension will depend on whether contributions are paid by the company or the individual. The pension limits may look to be far tighter in the forthcoming year, however restrictions known as Anti-forestalling Rules have limited recent contribution levels for top earners.

There are pros and cons of both ISAs and pensions. Both products are incredibly tax efficient, as they grow virtually tax free and neither investment is subject to Capital Gains Tax. Some of their other key features are as follows (space does not allow a full comparison here):

ISAs:

• Paid personally
• No tax to pay on income withdrawn
• Fully accessible at all times

Pensions:

• Paid personally or by the business
• 25% of final fund available as tax free cash, balance accessible through an annuity or income drawdown
• Accessible from age 55 onwards

So, let us return to the original question. For the sake of simplicity and because the vast majority of contractors fall into this category, I am going to assume that the individual operates through a limited company and takes income in the form of a small salary and dividends as required. In addition we shall assume that the investment is for 20 years to produce an income in retirement.

To actually answer the question as to what is the best income producing asset, we need to take a step back. The actual question should be “If I want to create a retirement income as tax efficiently as possible, from my limited company and income, how should I do it?” Remember that pension contributions can be paid by the company, ISAs personally. That means that for every £100 you bill as a contractor, £100 can be paid into the pension. As the contribution is an allowable expense, it reduces your Corporation Tax bill by 21% of the contribution. As ISAs are paid personally, we shall assume they are paid from dividends. If £750 is paid to the pension, the net equivalent is £592.50. If the payment comes from higher rate tax (HRT) dividends, the net equivalent is £405. So, if we project the contributions forward, it would look as follows:

Assumptions: Growth rate = 6% net of all charges; inflation; 2.5%; income/drawdown rate in retirement 5%; Corporation Tax 21%

However, ISA income can be taken tax free; only 25% of pension income is tax free. Having said that, the personal allowance increases significantly once you reach age 65, so the balance from the pension will only be taxed on a certain element. A fair comparison would now look as follows:

So, in answer to the question, the most tax efficient way for a contractor to save for retirement, is via company pension contributions. Having said that, we strongly recommend contractors utilise their annual ISA allowance where affordable, especially if they pay lower rate tax. In addition, there are other scenarios where ISAs would be preferable. For example, access before age 55, saving up for a lump sum. Finally, there are all the issues with regards to Inheritance Tax in later life. But, that is perhaps an article for another day.

Julian Gilbert

Financial Planner, Wealth Matters