Yahoo Finance Pension or buy-to-let: Which is best to fund your retirement?
Property or pension, which is best? Thousands of workers in their 50s and 60s will spend years poring over this question in the run up to their retirement. The right decision could mean the difference between thousands of pounds in income, not to mention a good night’s sleep knowing that your money is safe.
But the truth is that there is no clear-cut answer. Both ways of investing your cash come with the possibility of great returns, as well as risk.
Here, we explain the pros and cons of a traditional pension versus a buy-to-let portfolio. Remember that these factors will interact with each other and affect you in different ways, so it is important to consider each one carefully.
Why are pensions so good for savers?
Investment risk spread across stocks and bonds
Generous tax relief on contributions
Returns in a pension fund are free of capital gains tax
Employer contributions will help your pot grow
You can take a quarter of your pension completely tax-free at 55
Usually free of inheritance tax
A workplace pension is one of the best ways you can invest your cash. It allows you to invest in a range of stocks and bonds, and in most cases is managed by professionals so you do not need to worry too much about stock market moves.
They also offer generous tax relief on contributions at your marginal income rate, which significantly increases the value of your pot. Plus, any investment returns within a pension fund are free of income tax and free of capital gains tax.
You will also benefit from employers paying into your pot. Current rules dictate that they must contribute at least 3pc of your salary, and in many cases your workplace will match your own contribution. This means that the cash in your pension could effectively get a 100pc return, plus income tax relief, even before you get any investment gains.
This method of tax is known as “EET” – it means that contributions are exempt from tax on the way in, exempt from tax when they are growing, and then taxed when taken out as income.
But there is one more tax-free element – you can take a quarter of your pension completely tax-free once you hit the “normal minimum pension age”. This is currently set at 55, but is scheduled to increase to 57 by 2028, and could then soon after rise to 58 to follow any further state pension age increase.
Alice Haine, of the broker Bestinvest, added that pensions also got off lightly in terms of inheritance tax.
She said: “Pension funds can generally be passed on to the next generations free of inheritance tax – subject to the rules of the scheme and the age of the pension holder at death – whereas buy-to-let properties are liable to inheritance tax as part of an estate if it exceeds the nil rate band of £325,000.”
So what are the limits on my pension?
Investment returns are not guaranteed
After the tax-free lump sum, withdrawals are subject to income tax
There are limits on how much you can save into your pension tax-free each year
The Government has created a pension system that incentivises people to save for the long-term – but that does not mean it comes without risk.
First is that investment returns are never guaranteed. This means that your pension may lose some of its value. If it does not grow enough then it might not match inflation, which means that you will lose money in real terms.
Stocks and bonds can be volatile. This is fine for younger investors, as they have more time ahead of them to recover their losses. But for older workers, if the value of your pension drops overnight it could have serious implications on the outlook for your retirement, and you might have to work for longer.
Remember when you are planning out your retirement, after you take your 25pc lump sum, your withdrawals are also subject to income tax. You will need to consider this carefully when figuring out how big your pre-tax pot should be to fund possibly several decades of retirement.
Finally, there are limits on how much you can save tax-free into your pension. The first is the “annual allowance”, which for most people is £60,000. This includes your own contributions, tax relief and those paid by your employer.
This tapers down if you are a higher earner. This is calculated based on a "threshold" and "adjusted" income. The threshold income includes income from all sources, not just a person’s salary, such as investments and buy-to-let properties.
Adjusted income is calculated in a similar way but includes pension contributions that both employee and employer make from gross pay and via salary sacrifice.
If a person’s threshold income is more than £200,000 and adjusted income is more than £240,000 a year, then the annual allowance will drop from £60,000 to a minimum of £4,000.
The annual allowance falls by £1 for every £2 of adjusted income over £240,000. You can take advantage of unused annual allowances for the previous three years, if you have already used up all of your allowance this tax year.
There has been another limit known as the “lifetime allowance”, but this is about to be scrapped. It used to cap the amount that you can save into your pension overall. It had been frozen at £1.073 million since the 2020/21 tax year – but LTA charges will be removed starting from April 2023, and the cap will be abolished entirely from 2024.
Under rules being scrapped from April 2023, any savings over the limit are taxed at 55pc if the money is taken as a lump sum, or at 25pc plus the person’s income tax rate if taken out gradually.
It means if someone withdraws £100,000 of savings above the threshold at once, it would trigger a £55,000 tax bill. Untouched pension pots that exceed the lifetime allowance are taxed at 25pc above the threshold on the saver's 75th birthday.
Why use buy-to-lets as part of my pension?
Tangible asset supports your retirement
Reliable income from your tenants
Yields rival stock markets
‘Buy-to-let’ investing involves building up a portfolio of properties and then renting them out for income. This has proved hugely successful in recent years, thanks to a fortunate combination of rising rental prices and historically low borrowing costs.
Gordie Dutfield, of the property agency Redmayne Smith, said: “Property has long been considered an ‘alternative’ but it is a steady and reliable investment for many, especially into retirement.
“Even at the moment whilst the property market is turbulent, people still need places to live and rental demand remains high, so investors can rely on steady income from buy-to-let property, and this doesn't look to be wavering.”
Ms Haine said: “If you opt for a repayment mortgage, rather than the traditional interest-only, which many buyers go for as they offer flexibility to pay off the loan when rental income is more profitable, then you can build up equity over time.”
A key draw of buy-to-lets is the yields on offer to investors. A landlord who bought into the sector in 2015 will have seen their yield grow from 6.1pc to 7.2pc on average, according to data from the estate agents Hamptons.
Investors who have been in the sector for a few years have benefited from rising rental prices, as well as lower costs if they locked into a fixed-rate mortgage. A new investor in 2022 would have secured a yield around 6pc, Hamptons said.
However, prospective investors should bear in mind that these yields are calculated without taking tax or maintenance costs into account. When you include these, the numbers may not work in your favour.
How landlords are facing greater pressure
Tangible assets involve maintenance costs – and energy upgrades are coming
Tax rules are less generous
Mortgage rates are higher
Tenants’ rights are growing
Landlords are facing a huge amount of pressure, as mortgage rates, less generous tax treatments and tighter regulations build up. Demand for rental properties is still very strong, but profit margins are being squeezed on most sides.
One of the biggest costs to keep in mind is that while a tangible asset may give you a sense of comfort when planning your retirement, it often comes with much higher ongoing costs. In buy-to-let investing, maintenance costs can range from roof repairs, fixing damp or double-glazing windows.
In the next few years, a significant drain on landlord cash will be energy upgrades. Since April 2020, most landlords can no longer let properties that have an “Energy Performance Certificate” rating below E.
The Government is also drawing up plans that will block landlords from renting out properties unless they upgrade them to meet a minimum EPC rating of C within the next five years.
Ministers had previously proposed a deadline of 2025 for newly-let rentals, and 2028 for all other rented properties. However, the deadline is expected to be pushed back to 2028 for all properties, following warnings that the initial target was unachievable and driving investors out of the sector.
There are also plans for the sale of new gas boilers to be banned by 2035, meaning landlords will eventually need to install heat pumps, which can cost upwards of £10,000.
Unlike traditional pension saving, the buy-to-let sector does not get preferential tax treatment. In April 2016, a three percentage point stamp duty surcharge was introduced for additional property. The tapering of mortgage interest tax relief on buy-to-lets followed soon after.
This means that landlords now pay income tax on the entirety of their rental income, no matter how much is eaten up by mortgage interest.
This would not be so painful if investors’ capital were not up for grabs too. But the capital gains tax-free allowance will halve to £6,000 from April 6 this year, and then again from April 2024. This means that any increase in the value of your property while you own it could be subject to tax.
Capital gains are charged at a rate of 28pc for higher-rate taxpayers and 18pc for basic-rate taxpayers – both of which are 8pc higher than CGT on other assets such as stocks.
Ms Haine added that it is difficult for buy-to-let investors to diversify their portfolios in a meaningful way, unlike in a traditional pension.
“Even if their property portfolio contains different types of property in different price brackets across different locations, it remains a single asset class,” she said.
“There is also the risk of no income at all if a tenant cannot pay their rent or the property is difficult to rent out. Even short void periods can leave a significant dent on returns, particularly as the landlord will have to fork out for utility bills and council tax while it is empty.”
Ms Haine said: “While in the past people looked to a buy-to-let portfolio to fund retirement, the crackdown on landlords along with higher borrowing costs has made this option less attractive, particularly as accessing the capital you have tied up in properties is also a different kettle of fish to accessing a pension, as you end up with a big cash lump sum.
“Ultimately, running a buy-to-let portfolio only really makes sense as a source of retirement income when it is part of a diversified portfolio – one that also includes sizeable pension investments.”
