Should I invest in a buy-to-let property or a pension?

Pensions and the purchase of buy-to-let property continue to be popular investment vehicles for retirement planning.

Indeed, pension flexibilities have also resulted in many people considering withdrawing their pension to fund alternative investments, such as the purchase of buy-to-let property, however, there are a number of factors that should be taken into consideration when looking at these options.

Pensions or property?

Pensions are a tax wrapper for a variety of asset classes that can be easily purchased, held, switched and sold (usually without delay) as your need/situation changes or in response to economic movement.

A buy-to-let property is a directly held single asset class which would need to be sold if any reshaping of the investment is required, meaning you would need to find a purchaser (or enlist an agent to find a purchaser) who is prepared to pay the desired price at the required time.

Tax relief on pension contributions vs investment property

Individual contributions to a pension receive tax relief at the marginal rate of the investor, albeit within contribution limits, and the annual allowance. Your company also pays into your pension scheme but won’t if you opt out.

Pension contributions can be an effective way to manage potential Child Benefit and Personal Allowance ‘tax traps.’ These traps occur when an individual’s income exceeds certain thresholds - £60,000 when the High Income Child Benefit Charge is introduced and £100,000 before Personal Allowance is tapered – which leads to an increase in tax. Making pension contributions reduces your taxable income and these pension contributions benefit from tax relief.

What tax is payable on rental properties?

The purchase of buy-to-let property does not receive tax relief on the initial investment. Deposits to buy property are paid from taxed income, which is not reclaimable, and the rent received is taxable at the investor’s marginal rate.

On the sale of a buy-to-let property the profit is usually liable to Capital Gains Tax (CGT), and the Annual Exempt Amount reduced to £3,000 in 2024. Buy-to-let properties are also liable for Inheritance Tax (IHT) as part of the deceased’s (and any subsequent owner’s) estate, and income from inherited buy-to-let properties is liable to income tax irrespective of the date of death.

It is also worth noting that there is no guarantee that your property will always have tenants, which would impact rental income, and consequently could cause deficit issues if relied upon in retirement.

Pensions, IHT and income tax

While pension income is taxable, income earned from investments within a pension fund are free of income tax, and capital gains are also exempt from CGT.

Currently, pension funds (defined contribution schemes) can be passed down through generations free of inheritance tax. However, from April 2027, most unused pension savings and death benefits will be included in an individual’s taxable estate, and could potentially become liable to 40% IHT, ending their current exemption.

Pension funds are usually accessible income tax-free by beneficiaries if the pension holder dies before age 75, or taxed at the beneficiary’s marginal rate on death after age 75. This tax treatment is due to remain unchanged from April 2027 when the IHT changes are introduced.

Costs of a buy-to-let property and pension

Investing in property will incur initial and ongoing costs, including legal fees, potential stamp duty on purchase, potential landlord’s licence, letting agent fees, landlord insurance, energy certificates, potential court costs if needing tenant eviction and refurbishment costs, not to mention the costs of selling a property.

On the other hand, pensions have standard plan charges, which are clearly declared in the policy terms and conditions. However pension investments do not usually incur any further costs other than for advice if received from a financial adviser.

While most of these may be deductible from any profit made, if a pension had high annual product fees of 10-15% (which is a typical letting agent fee) it would be frowned upon by customers and the regulator alike.

What’s the best way to invest?

The question of how best to invest your money in order to secure a comfortable retirement is complex, and certainly one on which you should seek independent advice. Neither property nor pensions offer a guaranteed level of income, and both options carry risks as well as potential rewards.

No matter how much you're able to set aside, the current uncertain economic outlook and fluctuating markets mean that the old adage 'don't put all your eggs in one basket' has never been more appropriate.