3 Signs You Should STOP Paying Into Your Pension

0:00 One of the most expensive mistakes I see people make is to keep blindly paying into a pension when they shouldn't. When they'd be better off putting that money elsewhere. Although, what's often worse is stopping or dialing back your contributions when you should actually keep going. That can set your retirement back by years. I'm a financial planner and over the years I have seen both of these errors cost people tens of thousands of pounds. So, when does paying into a pension actually stop making sense? This is a question that I've been getting a lot due to all of the recent changes to pensions. People asking whether they should now be directing their money elsewhere.

0:35 But, here's the thing. For most of your working life, for most people, paying into a pension is one of the most powerful financial moves that you can make. But, there can come a point where paying in more starts to cost you even if your pension is relatively small. The trouble is that with all of these recent changes, it's made it much harder to see where that line is, whilst at the same time it's made knowing which side of the line you're on more important than ever. So, whether you are a basic higher or additional rate tax payer, or you're just worried about inheritance tax, I'm going to show you just how powerful pensions can be and the precise points where they can start to work against you. Here are some of the examples of the questions I've been getting. From 67, a full state pension is likely to use up all of your personal allowance, which means that any taxable income that you then draw from a personal pension will be taxed at the basic rate. If I'm a basic rate tax payer now, this means that I could pay just as much tax, if not more, when coming to take money out of my pension.

1:33 So, is it now worth saving more into ISAs? The second question I had from a client last week, I'm concerned about inheritance tax. Given the changes to pension IHT rules, should I be redirecting my savings elsewhere? And then the third question that I had on email, I'm 44 with 250,000 pounds in pensions. Based on what I'm paying in each month and an assumed growth rate of 8%, it's on track to grow above a million and 73,000 pounds. So, I'm already heading for the maximum tax-free cash. So, does it then make sense to start dialing back my contributions now?

2:02 There we have three people in very different situations who are all now wondering if a pension is still the best home for their money. Well, here's a way to think about it. In the UK, the main tax-efficient vehicles we have for building wealth are a pension and an ISA. An ISA is like a ship with one sail. It has one key tax advantage that helps it speed through the water, giving your money the potential to grow faster, which is that any growth or income you get within the ISA is protected from tax. And the same is true with a pension. They both have that same sail. But a pension has four other sails, four other distinct advantages that mean that, at least when it comes to retirement planning, a pension can have a lot more benefits. But the problem is that the power that those extra sails provide shifts as your situation changes and with the amount that you're contributing, to the extent that in certain situations, those sails don't provide any additional power and they can even become a drag, especially as the recent government changes have made each of these sails less effective and in one case, they've actually just cut it away completely. The additional sails are the income tax relief that you typically get when making a pension contribution, the 25% tax-free cash that you can withdraw at retirement, any employer contribution match that you get, and that pensions fall outside of your estate for inheritance tax purposes, which is the sail which is going to be cut away from April next year.

3:28 If you want to retire as early as possible or with the most income, you need to be able to identify exactly when each of these sails have stopped flying for you. But people often don't. They keep contributing when they shouldn't or they dial back their contributions because one sail is no longer flying without realizing that these other sails are still up and working just fine. Each time a sail goes slack, that is a sign, but it's a sign to look closer, not necessarily to stop, because what matters is how these work together, not how anyone works on its own. So, as we go through this, try and keep a tally against your own situation to understand where you sit. Now, let's start by looking at the difference between investing £1,000 into an ISA versus a pension. The key advantage that an ISA has over a pension is that you can get off the ship at any time. You can access that money whenever you want. Whereas with a pension, you can't start drawing that until 55 or 57 from 2028. But let's say that that's not a concern, and first look at this through the lens of trying to maximize income in retirement. And then we're going to look at this through the lens of inheritance tax, which is actually where I'm seeing people make the biggest mistakes at the moment.

4:39 Pensions and ISAs are they're just tax wrappers. Within them, you can invest in pretty much anything you want. So, let's assume that both this pension and ISA they're invested in the same thing. And for the sake of this example, we're going to ignore investment growth, just to make it easier to see the effect of each of these sales. With an ISA, £1,000 goes in, and when you come to take money out, there is no tax to pay, which leaves you with £1,000. With a pension, if you are a basic rate taxpayer, a £1,000 contribution gets 20% income tax relief added on top, which is effectively giving you a 25% boost. But if your employer uses a salary sacrifice pension, that contribution would avoid both income tax and national insurance, which is typically 8% for basic rate taxpayers. This NI saving would leave you with more taken pay. But so that we can compare apples with apples, let's assume that you also put that additional saving into your pension. The next question is what tax are you likely to pay when you come to take money out in retirement. You can typically draw up to 25% tax-free cash either as a lump sum, or you can take it bit by bit over time, whilst you pay marginal rates of tax on the other 75%. If you retire at 60 and you have no other income coming in, you could draw up to 12,570 pounds from the taxable part of your pension without paying tax. If you're able to draw it all out tax-free and you got basic rate tax relief going in, that would leave you 25% better off than the ISA. If that was via salary sacrifice, you'd be 29% better off. But, let's go back to that first question. What if you retire at 67 and you have a full state pension coming in, which is already using your personal allowance? And you then have to pay basic rate tax on all of your taxable pension withdrawals. Here, your effective rate of tax would be 15% assuming that you can also draw 25% tax-free cash. With salary sacrifice, this is still going to leave you 18% better off. Without it, it's just 6%.

6:35 Now, from 2029, a cap to salary sacrifice is being introduced, which means that only 2,000 pounds of your contributions will benefit from national insurance relief. Which means that if you earn up to 46,240 pounds and you're only contributing the default 5% of qualifying earnings to your pension, you won't actually be affected by this cap. But, if you earn more than that or contribute more than 2,000 pounds, then you're only going to get income tax relief on those contributions. Now, before we can draw any conclusions, there's one other sale that we need to think about and it's the biggest sale of them all. If your employer is also matching these contributions, that could double these numbers, leaving you 236% better off with an ISA, even if you end up having to pay basic rate tax relief on all of your withdrawals.

7:26 Just think about that. That leaves you with almost two and a half times as much money in retirement. This is where pensions are the most powerful and why it rarely ever makes sense to stop contributing to a pension entirely. But, here's the thing. Your employer will only match your contributions to a point. And from April 2029, salary sacrifice is going to have a limit, which means that any contributions that you make above these limits are only going to get basic rate tax relief. If you can draw that money out using your personal allowance, you'll still be well ahead. But, what if that's already spoken for? This is where the tax relief sale starts to get a bit limp. As the rules are today, you're still likely to be better off, but only just. And you've then got to weigh that against the flexibility and simplicity of an ISA and the risk that pension rules could change again. Although this slim margin is is actually why I think we're unlikely to see any further adverse changes to pensions, at least for basic rate taxpayers, because otherwise, there won't be much incentive to pay more into your pension once you've already got your employer match and you've hit the salary sacrifice cap. There is always an argument for diversifying between tax wrappers, but this is the point where it makes the most sense. And there's also the Lifetime ISA to consider. With these, you get a 25% government boost on the contributions you make and no tax on withdrawal, but you can only contribute up to £4,000 per year and that's only accessible without penalty from the age of 60. If that's not a concern, then these can be an effective tool to add to the mix. Now, before we get into inheritance tax, which is the one I think is going to surprise you the most, let's run the numbers for higher rate taxpayers. Here, you typically get 40% tax relief on the contributions you make. Salary sacrifice can also save an additional 2% national insurance, but let's ignore that given the upcoming changes. Clearly, that's already a pretty good head start, but what tax are they likely to pay at the other end? If they retired at 60 and had no other income coming in, as before, they could make use of their personal allowance and draw some of the taxable part of their pension tax-free. But, anything above that would be taxed at 20%. So, if they drew £40,000 £50,000 a year from the taxable part of their pension, they would pay about 15% income tax in total. But if they also have tax-free cash available, that brings the effective tax rate down to just over 11% leaving them 48% better off than with an ISA. If, however, their personal allowance is already spoken for, they'd be 41% better off. And if they end up having to pay higher rate tax on all of their taxable withdrawals, they'd be about 17% better off. Now, clearly, the tax relief sale can be really powerful for higher rate taxpayers. And of course, if these contributions were also getting matched by their employer, it would be multiples better. But let's instead focus on the pinch points. Much of this advantage is based on the assumption that these additional contributions will get more tax-free cash. But what if, as per our question, they won't? The maximum amount of tax-free cash that you can draw in your lifetime is typically £268,275, which means that if, based on the contributions that you are already making and projected investment growth, your pension is already on track to grow above a million and 73,000 pounds, then any additional contributions that you make are not likely to get you more tax-free cash. So, is this the point then when additional contributions stop making sense? Well, firstly, if your assumptions are wrong or the allowance goes up in the future, you risk turning the tap off too soon. And even if you think the tax-free cash sale is truly down, what about tax relief? If you get 40 or 45% income tax relief on a contribution and expect to pay basic rate tax on withdrawals, there is still a hefty net benefit. And in certain situations, it's possible to get even higher effective rates of tax relief, like if those contributions can help you reclaim benefits or keep you out of the 60% tax trap. So, to answer the question, even without tax-free cash, continuing to contribute can still be highly effective. But, as you approach the point where the tax-relief sale also falls away, a pension starts to look remarkably like an ISA. And, in these situations, which would you choose? We'd probably say an ISA, because it's simpler, it's more flexible, and you can even use it to make pension contributions in the future if your situation changes. You could also argue that it's less vulnerable to legislation changes, which is a real consideration.

12:08 Even if you run the numbers, and it looks like a pension is likely to leave you better off, if that benefit is only marginal, you may choose to look past that and diversify. We don't know what will happen to pension and ISA rules in the future, but you can be confident that those rules are going to change at some point. So, if you have all of your money tied up in one tax wrapper, you are leaving yourself exposed, and the argument for diversification gets stronger the lower each of these sales gets. Before we get onto inheritance tax, there are two critical things that we need to talk about. And, the first is that, once you've run the numbers for yourself, and identified where you sit on the scale, if you have a partner, you need to do the same analysis for them. Because, if you have a spare thousand pounds, you may find that contributing to their pension may actually be more effective than to yours. The second one is annual allowances. The maximum you can contribute to a pension each year is the lower of £60,000 or your relevant earnings. So, if someone earns £30,000 from employment, that's the maximum they can contribute. Whilst, if your adjusted net income is over £360,000, your allowance starts to get tapered down to just £10,000 if you earn over £360,000 per year.

13:23 However, it is possible, in such situations, to carry forwards unused allowances from the past three tax years. But once you've maxed all of those out, there are tax charges if you over contribute. So, in most situations, this is a sign to dial back your contributions. Now, I've given you a framework there to understand where you sit and to work this stuff out for yourself. But this stuff, it is really important. So, if you are unsure about any of this or perhaps you're not sure how to project what tax bracket you might be in in retirement, please do get in touch. There is a link in the description of the video where you can book in a call. Now, inheritance tax.

14:01 From April 2027, pensions are being brought inside of our estates for inheritance tax purposes. So, if you're concerned about IHT, should you now be diverting your contributions elsewhere? Well, the easiest way to avoid IHT is either to spend the money or to give it away. But let's say that you're not ready to do that right now. Let's again compare a £1,000 contribution to an ISA versus a pension. Given that most people who are concerned about IHT are higher-rate taxpayers, let's assume the pension contribution gets higher-rate tax relief. When you die, anything you leave to your spouse is exempt from IHT. But let's assume you're leaving this money to somebody else. So, 40% IHT is applied to both the ISA and the pension.

14:42 However, your ISA wrapper dissolves on death. So, that would leave them £600 in cash. Whereas a pension wrapper doesn't. The money remains inside a pension wrapper, which they inherit and can start to draw from right away. But the tax that they pay depends on when you died. If you died before the age of 75, your beneficiaries won't have to pay any income tax when they draw that money. Whilst if you died after the age of 75, they would have to pay marginal rates of income tax. If you then left your pension to, say, your grandchildren or other people who can make use of their personal allowance, they could potentially draw all of that money out tax-free by tactically drawing it down over time.

15:26 But, if you leave it to somebody who ends up paying basic or higher rate tax on all of those withdrawals, it's less effective. You've probably seen the headlines saying that pensions are now going to be double taxed, 64% or maybe even more than that. Well, this is where that comes from. But, if you think about it, even if they did pay 40% tax on the lot, your beneficiary is in exactly the same position as if you'd held that money with an ISA.

15:51 Now, don't get Don't get me wrong. They'd be in a much better position under the old rules, but if you die early or you are tactical with who you leave your pension to, when you look at it from end to end, a pension can still be a highly effective way to pass money onto future generations. And if you're perhaps able to get even more tax relief on the way in or perhaps even get those contributions matched by your employer, a pension it's still can still be an effective way to pass money on even when you're taking the full 40% IHT But, let's be honest, if you're actually concerned about IHT, you're probably more interested in how can I avoid it entirely? And the simplest way to do that is to give the money away.

16:29 And an ISA gives you the flexibility to make gifts without having to worry about income tax. Whilst with a pension, you may have to pay income tax when you draw the money. But, as we looked at earlier, if you pay less tax on the way out than the tax-free relief you got on the way in, not only does that leave you with more money to give away, but those gifts could potentially qualify for the gifts out of surplus income exemption and be outside of your estate immediately, straight away. Instead of having to wait the usual 7 years, which is what you typically have to do when you make a gift from an ISA. There are nuances to this strategy, so I will leave a link to it in the description of the video if you want to learn more about it. But, here's the thing.

17:12 I think it's really important to run this analysis based on the rules as you see them, based on how they are today. I mean, that's all we can do. But, we need to remember that it could be 20 or 30 years before you actually make this gift or you die. And, we have no idea what the rules are going to look like then. Which is why when it comes to IHT planning, just as with retirement planning, I think diversification is important, especially if one strategy looks like it's only going to have marginal benefits over another. Although, everything that I've said in this video is valid. In reality, if you have a thousand pounds to invest, it's not just a pension or an ISA you should be considering. There are lots of other things that you could be doing with that money.

17:52 Paying down a mortgage, general investment accounts, trusts, insurance, which is why if you really want to answer this question, you should watch this video here, where I assess all of these options and give you what I think is the optimal order to invest money. Look after yourself, and I'll see you in the next one.