When planning for retirement, it’s important to understand how the financial vehicles you choose can significantly affect your nest egg and the income it provides. Let’s explore the journeys of two hypothetical investors, David and Sarah, to illustrate the impact of their investment choices over their working lives and into retirement.
Meet David and Sarah: Two Different Approaches to Retirement Savings
Both David and Sarah are 30 years old and live on the Isle of Man, earning £50,000 per annum, and plan to retire at age 65. They both decide to contribute 10% of their annual salary towards retirement savings. However, their chosen paths diverge.
- David chooses a general investment account, contributing £5,000 annually. His investment grows at 5% per annum.
- Sarah works with a financial adviser and opts for an Isle of Man Pension Freedom Scheme, leveraging the 22% tax rebate on pension contributions. She contributes £6,410 annually gross (with a net personal contribution of approximately £5,000 after receiving the tax rebate). Her investment also grows at 5% per annum.
Both expect their earnings (and, consequently, contributions) to increase by 3% annually.
Part 1: Accumulation Phase
David’s General Investment Account
David’s general investment account grows during accumulation, but he doesn’t benefit from any tax relief on contributions. He may pay some tax on re-invested dividends depending on his underlying investments. Over 35 years, his contributions grow as follows:
- Initial Contribution: £5,000 annually, increasing 3% per year
- Investment Growth Rate: 6% per annum
Sarah’s Pension Freedom Scheme
Sarah contributes £6,410 gross annually, but the net cost to her is roughly the same as David’s (£5,000 after the 22% tax rebate). This extra gross contribution, compounded by investment growth, significantly boosts her retirement savings.
- Initial Gross Contribution: £6,410.26 annually, increasing 3% per year
- Investment Growth Rate: 6% per annum
- Tax Relief on Contributions: 22%
Final Balances at Age 65
Here’s how their respective balances compare at age 65:
David’s final balance: £838,194
- Total Contributions Over 35 Years: £302,310
- Investment Growth Over 35 Years: £535,884
David: No tax relief was available, so no savings during accumulation. May have attracted some tax on re-invested dividends depending on his underlying investments.
Sarah’s final balance: £1,074.564
- Total Gross Contributions Over 35 Years: £387,562 (includes tax rebate)
- Investment Growth Over 35 Years: £687,002
Sarah: Benefited from a 22% tax rebate on contributions, resulting in total tax savings of approximately £85,264.
Part 2: Retirement Phase
At age 65, both David and Sarah decide to draw a 6% income from their retirement savings annually. This income is designed to provide steady withdrawals while allowing their remaining savings to continue growing at 6% annually. They both remain medium-risk investors.
David’s Retirement Income
- Initial Balance: £838,194
- Annual Withdrawal (5% of balance): £50,292
- Income Tax Rate: 22%
- Tax Payable: £11,064 per year
- Net Annual Income: £39,227
Sarah’s Retirement Income
Sarah’s pension fund has a unique advantage: 40% of her fund can be taken as tax-free lump sum however she chooses to incorporate this into her annual withdrawals as her main investment goal is to drive maximum income.
- Initial Balance: £1,074,564
- Annual Withdrawal (6% of balance): £64,474
- Tax Payable on Taxable Portion (60%): £8,511
- Net Annual Income: £55,963
Income Comparisons (Age 65 – 82)
David
- Net Income Per Year: £37,227
- Total Net Income Over 17 Years: £666,687
Sarah
- Net Income Per Year: £55,963
- Total Net Income Over 17 Years: £951,376
Note: Calculations contained within this article contain rounding where required alongside various compounding assumptions.
Key Takeaways
- The Power of Tax Relief
Sarah’s decision to leverage the tax relief available on pension contributions provided her with significantly greater savings at retirement within a Pension Freedom Scheme. The 22% tax rebate on contributions not only allowed her to boost her initial contributions, with a very similar net cost to David but also allowed those extra funds to compound over 35 years. David may also have attracted some tax on re-invested dividends depending on his underlying investments, which has not been accounted for within this scenario. Within Sarah’s investment plan on the other hand, the investment returns can roll up tax-free.
- Retirement Income
Sarah’s pension scheme allowed her to draw significantly more income than David while paying proportionately less tax on the income due to the 40% tax-free portion of her withdrawals. Over 17 years, she received an additional £284,689 in net income compared to David and yet contributed broadly the same, net of tax.
- Tax Efficiency in Retirement
David’s general investment account was less tax-efficient in retirement, as all his withdrawals were taxable. Conversely, Sarah’s pension allowed her to optimize her withdrawals by incorporating the tax-free portion, reducing her overall tax liability.
- The Importance of Planning
Both investors contributed the roughly the same net amount over their careers. However, Sarah’s strategic use of a pension scheme in working with a financial adviser and the associated tax benefits, enabled her to achieve a larger nest egg, higher retirement income, and more tax-efficient withdrawals.
Conclusion: Maximising Retirement Savings
The comparison between David and Sarah highlights the power of pensions in retirement planning. Pensions not only provide immediate tax relief during your working years but also offer long-term benefits in terms of higher retirement balances and tax-efficient income strategies.
For retail investors concerned about providing sufficient income in retirement, the message is clear: leverage tax-advantaged savings vehicles like pensions whenever possible. By doing so, you can make the most of compound growth, tax savings, and income efficiency—ensuring a financially secure and comfortable retirement.
Where Does Your Financial Adviser Come In?
When planning for retirement, a financial adviser plays a crucial role in ensuring your pension strategy is aligned with your long-term goals. At Osborne Financial, we provide a holistic approach to retirement planning, helping you maximise tax relief and optimise pension contributions.
Our team will help simplify complex financial decisions, ensuring you’re fully prepared for retirement. If you’d like guidance on pensions or healthcare planning, contact us.
The information provided on the pages, blogs, and articles contained within this website are solely for information purposes only and do not constitute financial advice. Professional advice should always be sought from a financial adviser.
