ISA vs SIPP: Which tax wrapper should I use?
If you’re a British citizen over the age of 18, there is nothing to stop you from having both an ISA and a Sipp. Both are efficient wrappers to help your investments grow free of capital gains and dividend tax.
But which allowance should you use first? And are there other factors you should consider before setting up either account?
Absolutely. This article will compare the ISA and Sipp wrappers to help you make the best decision. Will be be covering:
The key differences between the Sipp and the ISA tax wrappers
Why long-term compounding has a greater impact in the Sipp
The restrictions on withdrawing money from your Sipp
Inheritance tax
What is a Stocks and Shares ISA?
An ISA is a tax-free savings account. Money saved within the ISA wrapper isn’t charged any tax on capital gains or dividends. All eligible ISA participants receive a £20,000 annual allowance. This renews at the end of each tax year on 5 April and you can’t roll your ISA allowance over into a new tax year. Use it, or lose it. For now, there is no upper limit for how much you can save in an ISA. The only restriction is your £20,000 annual allowance.
You can take the profits out of your ISA account at any time and you don’t pay any tax on the withdrawals.
What is a Sipp?
The Self Invested Personal Pension (Sipp) is a wrapper which allows you to save for your retirement free of capital gains and income tax. The Sipp allowance is part of your overall pension allowance - you can save the equivalent of 100% of your income in your pension (up to £60,000) every year. This allowance can be rolled over for three years.
When you contribute to your Sipp, the government will top up your contribution by 20% to compensate for the income tax you have already paid on that money. If you are a higher rate income tax payer, you can apply for additional tax relief.
Any money saved in your Sipp can be used to pay you an income in retirement. You can take 25% out as a tax free lump sum (up to a maximum of £268,250 -equivalent to 25% of the previous lifetime allowance) and then pay income tax on the rest of the savings. A Sipp can currently be withdrawn once you are 55, but the age limit will rise to 57 from 2028 and then increase in line with the retirement age.
The table below lays out the main differences between the ISA and Sipp.
ISA | Sipp | |
Maximum Annual Contribution | £20,000 | Equivalent of 100% of your earned income up to £60,000. |
Roll-Over | None | You can roll over your pension allowance for 3 years, meaning the most you can contribute in one year is £160,000 |
Lifetime Allowance | None | None (since the removal of the lifetime allowance) |
Income Tax Relief | No income tax owed at the point of sale. | Income tax added to personal contributions at the rate you pay tax. |
Capital Gains and Dividend Tax Relief | Yes | Yes |
Tax at the point of sale | None | 25% tax-free lump sum (maximum £268,250), the remainder taxed as income |
Restrictions on withdrawal | None | Sipp savings can’t be withdrawn until the age of 55 (this will increase to 57 in 2028 and then rise inline with the UK retirement age) |
Inheritance Tax | Yes | No |
Sipp vs ISA: Which is better?
The ISA and the Sipp are both fantastic wrappers for investors looking to shelter their savings from the tax man - the right answer to the question “should I use the ISA or the Sipp” is “both”. But there are scenarios where one of the two offers superior benefits. The sections below will run through the times that either the ISA or the Sipp is a better wrapper.
Scenario 1: The effects of compounding
The main difference between the ISA and the Sipp is the timing of your income tax bill. Your savings in the ISA (assuming you are funding them with your income) will be taxed prior to entering the tax wrapper. By contrast, the government will reimburse you for the income tax you have paid on savings which you then put into your Sipp. Any contribution you make to your Sipp will receive an automatic 20% boost and you can apply for further rebates if you are a higher or additional rate income tax payer (although you will have to add that money into your Sipp yourself).
That means that for the same level of personal saving, your Sipp will benefit from a bigger contribution. And on that bigger contribution, the work of compounding can have a greater impact.
The two charts below shows what that difference means in practice for a saver who puts £10,000 into both their ISA and Sipp for 20 years (assuming 4% annual portfolio returns and 20% government tax rebate).
After 20 years, the ISA would have grown to almost £310,000 whereas the Sipp would have grown to more than £371,000. More significant is the total profit on the initial investment. Both accounts would have received total personal contributions of £200,000 over the 20 years, meaning the profit on the Sipp would be £171,630, compared to a profit of £109,692 in the ISA.
For higher and additional rate taxpayers the benefit is even greater. A higher rate taxpayer will receive an immediate return on the money saved in their pension, even before any investment returns.
Winner: Sipp
Scenario 2: Withdrawal
Money saved in an ISA can be withdrawn at any time, whereas the savings in your Sipp are locked away until your retirement (or thereabouts). For now, Sipp investors can access their money at the age of 55, but in 2028 this will be raised to 57 and then increase in line with the national retirement age.
It is also worth being aware of the taxes you will pay on your Sipp once you retire. While the money saved in your Sipp is free of CGT and dividend tax (just like the ISA), there is no avoiding the income tax bill forever.
You can only take 25% of your Sipp as a tax free lump sum and then you pay income tax, just as with an ordinary pension income. Taking the numbers from the example above, the Sipp investor would only be able to take £92,907 of their savings tax free, the rest of the savings (£232,269) would be subject to income tax as it is drawn as a salary from the wrapper.
Those taxes have the potential to be painful for any retiree who takes a pension income which places them in the higher tax bracket. But, just like a salaried income, pensioners have a personal allowance of £12,570 - for many savers drawing from their Sipp prior to receiving their state pension, it is possible to draw from the account without paying income tax.
Winner: ISA
Scenario 3: Utilising a windfall
Sale of a house? A big bonus at work? Inheritance? If you are especially flush with cash in one year, your annual ISA allowance might not be big enough to benefit. The £20,000 annual allowance is stuck at the same level every year - you can’t roll it over. But with the Sipp your £60,000 annual allowance can be rolled over for three years, meaning the most you can contribute in any one year is £180,000 (three years of rollover and the £60,000 allowance in the current year).
Winner: Sipp
Scenario 4: Inheritance
When you are thinking about estate planning, remember that all of the money in your pension, including that in your Sipp is free of inheritance tax. The money saved in your ISA is not and any beneficiaries of your investments will have to pay the 40% tax on the assets in your ISA (unless any of those assets qualify for Business Property Relief (BPR), as certain AIM-listed shares do.
In later life, if you have money in both your ISA and your Sipp you are better off spending your ISA savings ahead of your Sipp savings to minimise your potential IHT bill.
Winner: Sipp
As the scenarios above demonstrate, the Sipp can be an extremely beneficial wrapper for investors. But unless you are sure that you want to save the money for your retirement, the ISA is the superior wrapper. And don’t forget your workplace pension scheme, which sometimes offers additional benefits such as contribution matching and insurance for workplace accidents. If you are ever unsure of the right course of action, consult a professional.
About Megan Boxall
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For flexibility you cannot beat an ISA as all withdrawals are tax free income at any point in your life. Whereas with a SIPP you have to be age 55 to take tax free withdrawals then a host of other restrictions get triggered which limit further investments into the fund at the most critical time in your life right before retirement (was £4000 per year tax free just been increased to £10000).
Example, you're 66 starting your retirement, if you mix and match you can have 250K ISA pot invested in high yielding stocks averaging 5% and your state pension giving you £22500 income per annum tax free (ISA dividend withdrawal and the state pension), you've still got another £2000 available from your 12K allowance. Now add on your pension pot going into draw down or an annuity you've got more retirement income for longer as you can withdraw less from the pot. With an ISA there isn't a time limit for tax free benefits for a SIPP the tax free benefit expires at age 75 so all income taken is now taxable.
Good summary of the current position. Two issues:
Pensions are basically a tax arbitrage. Tax relief when funds go in and taxed when withdrawing.
- If a basic rate taxpayer 20% relief going in , and 15% (after 25% tax free) coming out.
- Higher rate tax is 40% going in and if at retirement a basic rate taxpayer, 15% coming out.
- Of course, one can get 60% when contributing if income between £100k and £125k.
When the article compares the compounding effect, it is comparing the ISA balance (no tax) with the SIPP pre-tax balance. The SIPP balance is 20% higher, which is the Govt tax relief going in, but hasn't/can't adjust for the tax coming out.
Political risk. Future tax rates are not guaranteed, nor is the 25% tax free lump sum. There is also no National Insurance on pensions, and as people over pension age pay lower taxes and receive a larger share of resources (health + state pensions) they will be seen as having broader shoulders (I hate that phrase) and become a target for future Chancellors.
The 25% tax free lump sum has been changed from a percentage to the lower of a fixed sum £268,250 and 25%. Watch that fixed sum be reduced or just eroded with inflation.
I also wouldn't be surprised if a pensions tax was introduced (like a dividend tax) at a lower percentage on those with pension income above £xpa. Unlikely? Just remember Insurance Premium Tax that started at 2.5% in 1994 and has been slowly increased and now is charged at two rates; 12% and 20%.
ISAs are not taxed so they are safer from future political meddling.
My view is you should reduce risk and have both ISAs and a SIPP.
Rather than drawdown I'm planning to use uncrystallised pension lump sum once a year (£100 fee each time with Jarvis SIPP - drawdown costs more).
Vanguard don't charge anything for drawdown, but investment options are limited to Vanguard funds and Vanguard ETFs. As Vanguard charges are very low anyway this might be useful for some people.
*Past performance is no indicator of future performance. Performance returns are based on hypothetical scenarios and do not represent an actual investment.
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Maximum annual contribution of £2880 net isn't just if unemployed. It's more generally if earned income is £3,600 or less.
Also, an important point about pensions is that they don't count towards capital if ever there is a need to receive means tested state benefits. If investments are held in an ISA then any capital value over £6000 would lead to a reduction or elimination of the benefits in such circumstances. So SIPPs are superior in this respect.