Sheltering your investments from tax is one of the simplest and easiest ways to nudge you closer to your financial goals. It means you get to keep more of your growth and income instead of HMRC nabbing a slice.
This explains why investors are so fond of self-invested personal pensions (SIPP) and individual savings accounts (ISA) as both come with attractive tax perks and advantages.
There are, however, some key differences between them. And it’s crucial to understand these before you shovel your hard-earned cash into either. If you select the wrong one for your specific goal, it could cause you problems down the line.
You may be aware that the choice between SIPP and ISA isn’t binary - you can do both, and this can often be a sensible approach.
But which one should you prioritise? Well, there are several factors that can influence the decision, such as when you need access to the money, the rate of tax you pay, your age, whether you’re still working or retired, and the amount of tax you expect to pay in the future.
Further down, I provide an example of how SIPPs and ISAs can work in harmony. But first, let’s take a whistle-stop tour of the features and benefits.
What are the basics?
While SIPPs and ISAs are both “tax wrappers”, which simply means they wrap around your investments to shield them from the taxman, different rules apply to each.
Simply put, a SIPP is a type of pension that offers a wide investment choice and lots of flexibility. You can use one to grow your wealth or draw a retirement income. As with any pension, the feather in its cap is that you get a 25% boost from the government on whatever you pay in (within certain limits) and can claim back extra if you pay 40% or 45% tax. Your money grows tax-free too, but any income you take in the future is taxable.
An ISA, meanwhile, is a type of savings or investment account that you can access at any time, and you pay no tax on any interest, growth, and dividends.
There are five types of ISA, although only four can be used to save and invest for your own financial future; the other is a Junior ISA, which is only available to under 18s. You are free to mix and match between the various ISAs, but are limited to one of each type in any given tax year.
The two most-popular types are Stocks and Shares ISA and Cash ISA. With the former, you invest in things such as shares and bonds, which can move up and down in value. A Cash ISA works like a normal savings account, except you don’t pay tax on any interest you receive.
- Five questions to ask about your workplace pension
- My first four years as an ISA investor
- Six steps to manage your own wealth
The remaining two ISA types are Lifetime and Innovative Finance. The Lifetime ISA offers the added perk of a 25% bonus on what you invest every year, but the money must be used to buy a first home or for your retirement.
If investing in peer-to-peer loans (where you lend money directly to borrowers) is your thing, then an Innovative Finance ISA might be for you.
To help you understand more about how SIPPs and ISAs compare, here's a table to show the key differences:
|Access||The earliest you can access the money is age 55, rising to 57 from 2028. 25% of the fund is typically tax free, while the rest is taxed as income at your marginal rate of tax.||You can access the money whenever you want. The exception is the Lifetime ISA - you will be charged 25% unless the money is used to buy a first home or from age 60.
Junior ISAs can be opened only by a child's parent or guardian. The funds in a Junior ISA remain locked away until the child turns 18.
|You get up-front tax relief on what you pay in, and you pay no tax on growth and dividends. When you draw the money out, 25% of the fund is typically tax free, while the rest is taxed as income at your marginal rate.||Any interest, growth and dividends are free from tax.|
|A SIPP does not form part of your estate for IHT purposes. If you die before age 75, the beneficiary pays no tax. If you die after 75, they will pay tax at their marginal rate on any income they receive.||Any ISA money typically forms part of your estate for IHT purposes.|
|Annual investment limit||The lower of £60,000 or 100% of earnings. Although you could be limited to £10,000 if your earnings exceed £260,000, or you have started to draw income from your pensions.||£20,000 a year. Lifetime ISA max is £4,000 a year, which is included in the £20,000 allowance.|
|Lifetime limit||The lifetime allowance, which levied a tax charge on pensions funds above £1.07 million, will be abolished from 6 April 2024.||None.|
Minimum age is 18, and you can pay into a SIPP and get tax relief until age 75.
There is no upper age limit.
Minimum age is 18 for ISAs except Cash, which is age 16. There is no minimum age to open a Junior ISA. When the child is 18, the account becomes a standard ISA.
No upper age limit except the Lifetime ISA, which must be opened before your 40th birthday and contributions can only be made until age 50. If using for retirement, the earliest you can access is age 60.
Which one should take priority?
Before you make any decisions about your long-term future, you should establish the reason why you’re saving.
The standard guidance is that if you plan to use the money for your retirement - and are happy to forgo access until then - a SIPP should be a better option. But if you need the money before you retire, or the earliest age you can access your pension, then consider an ISA as you can dip into it whenever you like.
But how this works requires a bit more explanation. With SIPPs, you get tax relief on the way in but, other than the 25% tax-free lump sum, you will probably pay tax on the way out. With ISAs, the tax rules are reversed; you don’t get relief on what you contribute but any withdrawals are tax-free.
Let's crunch some numbers and see how the figures stack up.
Case study: how SIPPs and ISAs can work in harmony
Gina is 43 and runs her own company as a sole trader. Her pre-tax profits are £60,000 a year. Gina has a £15,000 lump sum to invest for her future and wants to access this money in seven years’ time to buy a new car. She has held back 12 months’ expenditure in a savings account to cover emergencies. Gina also has a spare £500 a month that she would like to put towards boosting her retirement income. She is on track to receive the full state pension and has a small defined benefit (DB) pension scheme from a previous job.
- Seven pension tips I learned as a financial adviser
- Seven ways to keep your retirement finances in shape
- Four reasons to be hopeful about your retirement
So, what are Gina’s options for the £15,000 lump sum?
As the earliest Gina will be able to draw money from pensions is age 57, a SIPP isn’t much use to her here. However, she can access an ISA whenever she wants, and her lump sum is within the £20,000 a year annual limit. As she has an investment time horizon of seven years, it might make sense to opt for a Stocks and Shares ISA over a Cash one, as stock markets tend to outpace cash savings over longer periods.
For the £500 a month, the situation is a bit more complicated. Because she doesn’t need the money until age 68, both SIPPs and ISAs are on the table. Let’s run some numbers and see what a £500 a month contribution would provide in retirement, examining both what she could accumulate and how this would translate to income. For each scenario, I’ve assumed the money grows at 5% a year and Gina will pay 20% income tax once she retires.
Monthly payment: £500
Total payments over term: £150,000
Cost of total payments: £150,000
Pot accrued at 5% growth: £299,000
Annual income at 5%: £14,950
Tax on income: 0
Net income: £14,950
Monthly payment: £625 (£500 + £125 government top up)
Total payments over term: £187,500
Cost of total payments: £112,500 (additional 20% tax as Gina is a higher-rate taxpayer - totalling £37,500 over the term - claimed back on self-assessment)
Pot accrued at 5% growth: £374,000
Annual income at 5%: £18,725
Tax on income: £2,808.75 (no tax on 25%, basic-rate tax paid at 20% on remainder)
Net income: £15,916
There are two important figures to focus on here. The first is the total payments over the term. Due to pension tax relief, Gina’s total payments of £187,500 only cost her £112,500. That’s because she gets an immediate boost from the government and can claim back a further 20% of the gross amount as she’s a 40% taxpayer. You start paying higher-rate tax once income exceeds £50,271. As her income is £60,000, the full annual pension payment of £7,500 (£625 x 12) qualifies for 40% relief.
- Annuity rates are high: should I buy?
- My ISA goals for 2023: why I’m feeling ‘queasy’ but quietly confident
The second figure to cast your eyes over is net income. Not only will Gina have committed £37,500 less to her SIPP over the term, but will also boost her later-life income by almost £1,000 a year, even once 20% income tax has been deducted. This explains why higher-rate taxpayers typically favour SIPPs over ISAs when saving for retirement. But even if Gina paid basic-rate tax during her working life, a SIPP would still be favourable – although by a smaller margin.
Here’s another thought. If every year Gina invested the £1,500 (£125 x 12) reclaimed in income tax into a Stocks and Shares ISA (Gina's not eligible for the Lifetime ISA as she's over age 39), which grows at 5% a year, she could amass an additional sum of £72,750. This could provide an extra £3,638 in tax-free income – taking her total net income to £19,554. Interestingly, with the same monthly cost of £500, combining SIPPs and ISAs (£3,638 + £966 (£15,916-£14,950)) has increased her retirement income by £4,604 a year. What’s more, she can dip into her ISA at any point without adding to her income tax bill, widening her options both before and during retirement.
I’ve clearly used lots of assumptions here, and this must not be construed as advice. What is right for you will depend on your personal circumstances. If you're employed and have access to a workplace pension which your employer must pay into providing you do too, it's key to make the most of this before considering a SIPP. I’ve also taken no account of inflation, which will erode the buying power of Gina’s money over time.
But what it serves to highlight is that with a bit of thought, SIPPs and ISAs can join forces to give you a valuable blend of tax efficiency, retirement income, and accessibility.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.
Please remember, investment value can go up or down and you could get back less than you invest. If you’re in any doubt about the suitability of a stocks & shares ISA, you should seek independent financial advice. The tax treatment of this product depends on your individual circumstances and may change in future. If you are uncertain about the tax treatment of the product you should contact HMRC or seek independent tax advice.
Important information – SIPPs are aimed at people happy to make their own investment decisions. Investment value can go up or down and you could get back less than you invest. You can normally only access the money from age 55 (57 from 2028). We recommend seeking advice from a suitably qualified financial adviser before making any decisions. Pension and tax rules depend on your circumstances and may change in future.