There was a recent post comparing ISAs and pensions, and it drew a lot of attention to the timing of tax relief. The wiki does cover this here, but even when I read this I was still not convinced because the example given didn’t feel nuanced enough.
I’m going to try and explain it in a more mathsy way which I found more satisfying, and then I’m going to explain why I still don’t like it as a statement in the context of pensions specifically.
Heads up before jumping in, this is quite a niche post written in a way that I found helpful for myself to understand and feel confident in some of these principles. Most people do not need to care and can just follow the advice on the wiki, and many people will already know this. But for the remaining boring and curious people like me, please enjoy.
Why the timing of tax relief doesn’t matter
So let’s just use basic rate tax (BRT). Meaning whatever number we start with (“x”), the after tax version of that number will be x * 0.8.
If there was no growth to care about, the maths would be easy, you start with contribution x, and if you get taxed now or in 50 years, the final answer is still x * 0.8
No growth
Vehicle
Value now
Value later
ISA (tax now)
x * 0.8
x * 0.8
Pension (tax later)
x
x * 0.8
Anyone could have worked that out. Now let’s look at growth.
Scenario one, let’s assume 10% growth in value and that’s it. No compounding. So we’ll take the value now (with or without tax), multiply by 1.1, and then take any tax off if required.
Flat growth
Vehicle
Value now
Value later
ISA (tax now)
x * 0.8
x * 0.8 * 1.1
Pension (tax later)
x
x * 0.8 * 1.1
Again, that’s probably not what you’re here for. Ok, compounding time. 10% year 1, 10% year 2… 10% year 20. In fact 10% year n.
I’m sure you all remember this from GCSE maths, but to work out compounding you can take some starting number and multiply it by 1 + the growth as many times as you want.
Years of growth
Value
Value (simplified)
1
x * 1.1
x*1.1
2
x * 1.1 * 1.1
x*1.1[sup]2[/sup]
3
x * 1.1 * 1.1 * 1.1
x*1.1[sup]3[/sup]
20
x * 1.1 * 1.1…
x*1.1[sup]20[/sup]
n
x*1.1[sup]n[/sup]
And some of you might have now seen the trick. 1.1[sup]n[/sup] is just an arbitrary multiplier, just like when we had flat non-compounding growth. We could replace the number 1.1[sup]n[/sup] with anything, so let’s just call it y. Now compounding growth looks like this
Compound growth
Vehicle
Value now
Value later
ISA (tax now)
x * 0.8
x * 0.8 * y
Pension (tax later)
x
x * 0.8 * y
Hey look, it’s the same! This is the bit that got me when I was first trying to get my head around this. I was sure that compound growth would be more beneficial earlier on, but that’s not relevant if the tax coming out is the same as the tax going in. So if the rate of the tax is the same coming out as it is going in then the timing doesn’t matter.
Why that’s an oversimplification (especially for pensions)
The above is correct if we assume a really simple 20% tax on everything. Now there are a couple of obvious examples of why this isn’t always true, namely:
HRT now BRT later
HRT = 0.6
BRT = 0.8
Vehicle
Value now
Value later
ISA (tax now)
x * HRT
x * HRT * y
Pension (tax later)
x
x * BRT * y
Vehicle
Value now
Value later
ISA (tax now)
x * 0.6
x * 0.6 * y
Pension (tax later)
x
x * 0.8 * y
25% tax free
BRT = 0.8
After Tax Free BRT (ATFBRT) = 0.25+(0.75*0.8) = 0.85
Vehicle
Value now
Value later
ISA (tax now)
x * BRT
x * BRT * y
Pension (tax later)
x
x * ATFBRT * y
Vehicle
Value now
Value later
ISA (tax now)
x * 0.8
x * 0.8 * y
Pension (tax later)
x
x * 0.85 * y
These are the two obvious ones and probably the most applicable to most people. There is a sneaky third that is applicable to some people, and that is drawing down from the pension either entirely or partially below the personal tax allowance. So let’s pretend you’re able to do this (perhaps between ages 58 and 68 when you only have your pension income and don’t need a lot to live on). Well then you pay no tax in retirement
Vehicle
Value now
Value later
ISA (tax now)
x * 0.8
x * 0.8 * y
Pension (tax later)
x
x * y
This is unlikely to be possible when claiming state pension, but if retiring early (well, at an age where you can draw down from a private pension but don’t receive state pension (I think there is a name for this)) it’s likely that a significant chunk of your tax burden is reduced by the personal allowance
I think most people know the HRT/BRT thing. HRT payers are obviously utilising pensions now even if they don’t know the exact impact on ROI. It’s the tax free allowance and the personal allowance that I think have such an impact on the pension vs ISA debate that it means the wiki statement muddies the waters. Yes - if it was 0.8 now and 0.8 later, then it would make ISA and pensions more apples to apples - but it’s extremely common for it to actually be a comparison of 0.8 to 0.85 (if not better), so use your pension!
Shameless plug for another post I made which highlights the effective ROI of different retirement vehicles for different scenarions
Bonus: what about reaching a “financial independence” / “4% rule” sum faster
This is the idea that as long as you are withdrawing from your retirement fund less than it’s growing, you’ll never run out of money. So surely if you can get to some sum which allows for this perpetual growth faster, that means you can retire earlier right?
Well sort of. Again, if the rate of tax at the start was the same as the rate of tax at the end, then no actually this wouldn’t be true. Yes you might only need 15 years of pension contributions to meet some predetermined sum compared to 20 years of ISA contributions, but that’s misleading because you’d need a higher sum in the pension than the ISA because you need to withdraw more from it to get the same amount after tax. Example:
£10k needed per year to live
10% growth each year
BRT on pension withdrawals (we’re ignoring tax allowances for now)
Vehicle
Yearly draw down needed
Sum needed for FI
ISA (tax now (*0.8))
£10k
£100k
Pension (tax later (*0.8))
£12.5k
£125k
So assuming the same tax rate, there’s no difference in when you can start to drawn down. However, we’ve discussed at length that more than likely your retirement tax rate is less than your pre-retirement tax rate.
Vehicle
Yearly draw down needed
Sum needed for FI
ISA (tax now (*0.8))
£10k
£100k
Pension (tax later (*0.85))
£11.76k
£117.6k
A bit of mental gymnastics here because CBA to make the example more fleshed out, but in the example where tax in=tax out you needed £125k in the pension, whereas when tax in>tax out you only needed £117.6K, which is like 94% of the amount (and not quite 94% of the time because maths).
So the FI sum argument is identical to the tax now/later argument: if the rate of tax is the same then there is no difference when FI is reached, but if the rate of tax in retirement is lower then you reach FI sooner.
Edit: having reread the this wiki page (which contains the section on tax relief timing), I actually do think it does a good job of explaining the likely differences in rates. The final section which simplifies the tax relief maths is fine in the broader context
I’m going to try and explain it in a more mathsy way which I found more satisfying, and then I’m going to explain why I still don’t like it as a statement in the context of pensions specifically.
Heads up before jumping in, this is quite a niche post written in a way that I found helpful for myself to understand and feel confident in some of these principles. Most people do not need to care and can just follow the advice on the wiki, and many people will already know this. But for the remaining boring and curious people like me, please enjoy.
Why the timing of tax relief doesn’t matter
So let’s just use basic rate tax (BRT). Meaning whatever number we start with (“x”), the after tax version of that number will be x * 0.8.
If there was no growth to care about, the maths would be easy, you start with contribution x, and if you get taxed now or in 50 years, the final answer is still x * 0.8
No growth
Vehicle
Value now
Value later
ISA (tax now)
x * 0.8
x * 0.8
Pension (tax later)
x
x * 0.8
Anyone could have worked that out. Now let’s look at growth.
Scenario one, let’s assume 10% growth in value and that’s it. No compounding. So we’ll take the value now (with or without tax), multiply by 1.1, and then take any tax off if required.
Flat growth
Vehicle
Value now
Value later
ISA (tax now)
x * 0.8
x * 0.8 * 1.1
Pension (tax later)
x
x * 0.8 * 1.1
Again, that’s probably not what you’re here for. Ok, compounding time. 10% year 1, 10% year 2… 10% year 20. In fact 10% year n.
I’m sure you all remember this from GCSE maths, but to work out compounding you can take some starting number and multiply it by 1 + the growth as many times as you want.
Years of growth
Value
Value (simplified)
1
x * 1.1
x*1.1
2
x * 1.1 * 1.1
x*1.1[sup]2[/sup]
3
x * 1.1 * 1.1 * 1.1
x*1.1[sup]3[/sup]
20
x * 1.1 * 1.1…
x*1.1[sup]20[/sup]
n
x*1.1[sup]n[/sup]
And some of you might have now seen the trick. 1.1[sup]n[/sup] is just an arbitrary multiplier, just like when we had flat non-compounding growth. We could replace the number 1.1[sup]n[/sup] with anything, so let’s just call it y. Now compounding growth looks like this
Compound growth
Vehicle
Value now
Value later
ISA (tax now)
x * 0.8
x * 0.8 * y
Pension (tax later)
x
x * 0.8 * y
Hey look, it’s the same! This is the bit that got me when I was first trying to get my head around this. I was sure that compound growth would be more beneficial earlier on, but that’s not relevant if the tax coming out is the same as the tax going in. So if the rate of the tax is the same coming out as it is going in then the timing doesn’t matter.
Why that’s an oversimplification (especially for pensions)
The above is correct if we assume a really simple 20% tax on everything. Now there are a couple of obvious examples of why this isn’t always true, namely:
- If you pay HRT now and will pay BRT later
- You get 25% tax free on all your pension
HRT now BRT later
HRT = 0.6
BRT = 0.8
Vehicle
Value now
Value later
ISA (tax now)
x * HRT
x * HRT * y
Pension (tax later)
x
x * BRT * y
Vehicle
Value now
Value later
ISA (tax now)
x * 0.6
x * 0.6 * y
Pension (tax later)
x
x * 0.8 * y
25% tax free
BRT = 0.8
After Tax Free BRT (ATFBRT) = 0.25+(0.75*0.8) = 0.85
Vehicle
Value now
Value later
ISA (tax now)
x * BRT
x * BRT * y
Pension (tax later)
x
x * ATFBRT * y
Vehicle
Value now
Value later
ISA (tax now)
x * 0.8
x * 0.8 * y
Pension (tax later)
x
x * 0.85 * y
These are the two obvious ones and probably the most applicable to most people. There is a sneaky third that is applicable to some people, and that is drawing down from the pension either entirely or partially below the personal tax allowance. So let’s pretend you’re able to do this (perhaps between ages 58 and 68 when you only have your pension income and don’t need a lot to live on). Well then you pay no tax in retirement
Vehicle
Value now
Value later
ISA (tax now)
x * 0.8
x * 0.8 * y
Pension (tax later)
x
x * y
This is unlikely to be possible when claiming state pension, but if retiring early (well, at an age where you can draw down from a private pension but don’t receive state pension (I think there is a name for this)) it’s likely that a significant chunk of your tax burden is reduced by the personal allowance
I think most people know the HRT/BRT thing. HRT payers are obviously utilising pensions now even if they don’t know the exact impact on ROI. It’s the tax free allowance and the personal allowance that I think have such an impact on the pension vs ISA debate that it means the wiki statement muddies the waters. Yes - if it was 0.8 now and 0.8 later, then it would make ISA and pensions more apples to apples - but it’s extremely common for it to actually be a comparison of 0.8 to 0.85 (if not better), so use your pension!
Shameless plug for another post I made which highlights the effective ROI of different retirement vehicles for different scenarions
Bonus: what about reaching a “financial independence” / “4% rule” sum faster
This is the idea that as long as you are withdrawing from your retirement fund less than it’s growing, you’ll never run out of money. So surely if you can get to some sum which allows for this perpetual growth faster, that means you can retire earlier right?
Well sort of. Again, if the rate of tax at the start was the same as the rate of tax at the end, then no actually this wouldn’t be true. Yes you might only need 15 years of pension contributions to meet some predetermined sum compared to 20 years of ISA contributions, but that’s misleading because you’d need a higher sum in the pension than the ISA because you need to withdraw more from it to get the same amount after tax. Example:
£10k needed per year to live
10% growth each year
BRT on pension withdrawals (we’re ignoring tax allowances for now)
Vehicle
Yearly draw down needed
Sum needed for FI
ISA (tax now (*0.8))
£10k
£100k
Pension (tax later (*0.8))
£12.5k
£125k
So assuming the same tax rate, there’s no difference in when you can start to drawn down. However, we’ve discussed at length that more than likely your retirement tax rate is less than your pre-retirement tax rate.
Vehicle
Yearly draw down needed
Sum needed for FI
ISA (tax now (*0.8))
£10k
£100k
Pension (tax later (*0.85))
£11.76k
£117.6k
A bit of mental gymnastics here because CBA to make the example more fleshed out, but in the example where tax in=tax out you needed £125k in the pension, whereas when tax in>tax out you only needed £117.6K, which is like 94% of the amount (and not quite 94% of the time because maths).
So the FI sum argument is identical to the tax now/later argument: if the rate of tax is the same then there is no difference when FI is reached, but if the rate of tax in retirement is lower then you reach FI sooner.
Edit: having reread the this wiki page (which contains the section on tax relief timing), I actually do think it does a good job of explaining the likely differences in rates. The final section which simplifies the tax relief maths is fine in the broader context