SIPPs versus ISAs: an investment guide

10 March 2018

Individual savings accounts (ISAs) and self-invested personal pensions (SIPPs) are both tax-efficient wrappers that can be used to save money for retirement.

What Investment compares the two.

ISAs can also be used to save money for a rainy day, as the money can be accessed anytime, whereas you cannot get your hands on the money in your SIPP until your 55th birthday.

Both SIPPs and ISAs offer a wider choice of investments and greater flexibility than your average pension, giving investors the opportunity to achieve better returns if they make the right choices.

However, there are some important differences between the two vehicles, which are set out below.

Tax reliefs of SIPPs versus ISAs

Normally, you pay income tax on income from your investments, and capital gains on any growth in the value of those assets. Both ISAs and SIPPs allow you to protect your savings and investments from these taxes.

However, SIPPs also offers a tax top-up when you pay money in, at the rate of 20 per cent, or 40 per cent for a higher-rate taxpayer. So if you save £800 into a SIPP, the government will generously top that up to £1,000 (essentially giving you back the 20 per cent tax you would have paid on the £1,000). Higher-rate taxpayers can claim back an additional £200 through a self-assessment form.

ISAs don’t give you this benefit, but they do have one tax advantage over SIPPs. You don’t have to pay tax on money you withdraw from your ISA, whereas the taxman treats income that comes out of a SIPP in the same way as any other income, except for a tax-free lump sum of up to 25 per cent of your entire SIPP pot that you can claim at 55.

However, it’s likely that for most investors, SIPPs will work out as more tax-efficient. SIPPs are especially advantageous for those who expect to pay higher-rate tax while they are in work, and then basic-rate tax in retirement. However, they will also be beneficial to those who expect to pay basic-rate tax in both work and retirement.

Investment Returns SIPPs versus ISAs

Top cash ISAs currently offer interest rates of 1.1 per cent easy access and 2.15 per cent fixed for 2017/18 . The return from a stocks and shares ISA will obviously depend on the wisdom of your investments.

The return from a SIPP will equally depend on your investment decisions, but don’t forget the impact of the tax top-up of 20 per cent. Every £800 you pay in will automatically turn into £1,000, which you could see as an instant 25 per cent return.

Administration charges for SIPPs tend to be slightly higher than those for ISAs. This is because there is slightly more work and complexity involved for the provider. However, this extra cost pales into insignificance compared to the upfront tax break.

Contributions to SIPPs and ISAs

Even after a big boost to ISA allowances in the 2014 Budget, most people were still paying far more into SIPPs than ISAs.

From 6 April, 2017, the annual ISA allowance increased from £15,240 to £20,000 per each tax year, offering the potential opportunity for greater growth.

With a SIPP, you can contribute up to 100 per cent of your gross annual income. However, an additional limit of £40,000 also applies. So if you earn £30,000, you can contribute up to £30,000; if you earn £60,000, you can contribute up to £40,000.

However, there are three conditional exceptions:

• If you have accessed a pension since 5 April 2015, or have ever been in flexible drawdown, a reduced contribution limit may apply.
• If your 'adjusted income' is more than £150,000, your annual allowance could be tapered down to as little as £10,000 - equitable to your total taxable income plus the value of any employer pension contributions.
• If you take benefits from a pension due to what HMRC considers 'serious' or 'severe' ill health, you may not be limited by the the annual allowance for the tax year in which you take benefits.

If you're not a taxpayer

You can put in a maximum of £2,880 a year into your SIPP and still get the tax top-up of 20 per cent, giving you £3,600. This also applies to children, whose parents can contribute to a 'child SIPP' on their behalf.

Accessing your money in a SIPP or ISA

ISAs can be used as an emergency fund, with savings not locked away for the long term and not taxed as they’re withdrawn. SIPPs cannot be accessed until you turn 55, although this can be an advantage if you don’t trust yourself to leave the money alone until you retire.

From April 2015, the government made it much easier for retirees to take as much money out of their SIPP or pension as they wanted. However, it remained liable for income tax though, beyond the 25 per cent tax-free lump sum.

How to decide what assets to put in ISAs and SIPPs

If you have both ISAs and SIPPs, you need to give some thought on how to arrange your assets within these tax wrappers in the most tax-efficient way.

This is a complex subject, but in very general terms, ISAs are great for assets that produce income as interest, like bonds or cash. This is because that income will be entirely free from tax, both when it is paid to you and when you take money out of the ISA.

Currently these Individual Savings Accounts come in a number of different kinds, which all offer tax efficiencies to a degree, acting as wrappers around an investor's money.

At the time of writing there are four different types of ISAs, and an investor's choice of ISA should be based on desired goals and a clear awareness of one's perception of risk. Investors should also be aware that not all ISA providers actually provide this total cannon of ISAs.

The four ISAs are:

• The Cash ISA
• The Stocks and Shares ISA
• The Lifetime ISA

and

• The Innovative Finance ISA.

There is room to be strategic about how the £20,00 allowance is allocated: it is possible to put up to £20,000 into an ISA; alternately, during this tax period the sum can be split across the four ISAs, and each ISA can be held with different providers.

However, it's important to note that only a maximum £4,000 can be held in the new Lifetime ISA during the tax year (April 2017 - April 2018).

In addition, any unused ISA allowance cannot be carried forward into the next year.

It's a case of use it or lose it.

But, the flexibility this investment vehicle offers within any tax year is valuable; allowing an investor to replace any withdrawn money from a Cash ISA without impacting the annual ISA allowance.

Each ISA has specific entry criteria - an adult investor must be:

• 16 or over for a Cash ISA
• 18 or over for a stocks and shares or the innovative finance ISA
• 18 or over but under 40 for a Lifetime ISA
• Resident in the UK

As an adjunct, Junior ISAs are an interesting opportunity to introduce those under 18 to regular saving.

Junior ISAs were introduced on 1 November 2011 with an initial subscription limit of £3,600, which increased to £4,000 in July 2014 and to £4,080 for the 2015-16 tax year.

For the current 2017-18 tax year the limit is £4,128.

At age 18 the JISA converts to an adult ISA. Like adult ISAs, JISAs are available in both cash and stocks and shares types.

SIPPs, on the other hand, protect your income from tax as long as assets are inside the SIPP, but when you take money out of the SIPP it is liable for tax.

A balancing act

In very broad terms, the distinction to bear in mind is that SIPPs save you more tax over the long term but ISAs let you get your money out in a rush.

Remember that you don’t have to choose between ISAs and SIPPs, though; you can have both. A mixture of saving through SIPPs and ISAs will be most appealing to the majority of investors. This should enable you to manage both your medium-term and long-term savings.

Ingrid Smith is a senior content strategist, storyteller & mentor