Individual Savings Accounts (ISAs) and Self-Invested Personal Pensions (SIPPs) are two of the cornerstones of any long-term savings strategy.
The first thing to understand is that ISAs and SIPPs are not investments in themselves – they are simply ‘wrappers’ in which investments are held. The government wants to encourage us all to save for our future needs, so it offers tax breaks on money placed within these wrappers.
Each year, all UK residents are allowed to tuck a certain amount of money away in both an ISA and a SIPP. And if you have sufficient savings to take advantage of both, then you should consider them. SIPPs should be seen as a part of your overall retirement planning, and you should make sure it is the right product for you. If you are in any doubt then you should seek Independent Financial Advice.
But if you are saving less than the annual allowance for each (and most of us are), then how do you choose which is most suitable for you? Here are the key factors to consider.
Cash ISAs: a good home for short-term savings
Every UK adult can put up to £20,000 into an ISA in the 2017/18 tax year (which runs to 5th April 2018). This ‘ISA allowance’ can be split between the four ISA types: Cash ISA, Stocks & Shares ISA, Innovative Finance ISA and the new Lifetime ISA,which will be available to young people aged pver 18 and under 40 but has a maximum subscription of £4,000 per year.
While you can hold cash in a Stocks and Shares ISA, it still generally makes sense to hold cash savings that you might need to call on in a hurry (an emergency fund, for example) in a separate instant-access ISA, perhaps with your bank.
However, interest rates on cash ISAs are currently very low, although you don’t have to pay tax on the interest income. So if you are saving for a long-term goal (five years or more) then it could make sense to take more risk with your money so that it has the potential to grow faster. That means investing it.
Young people may wish to consider using a Lifetime ISA, which is designed to help save towards buying your first home or your retirement. The limit you can pay into a Lifetime ISA is £4,000 per tax year (which forms part of your overall ISA allowance for the year) and for every pound you pay in, you will receive a 25% bonus from the Government. If you aren’t a first time buyer or you need to access the money before age 60 for any other reason, you may be subject to a penalty charge. (Do bear in mind that if you subscribe to a Lifetime ISA instead of enrolling in a pension scheme, you may lose the benefit of your employer's contributions. Also, subscribing to a Lifetime ISA could affect your current and future entitlement to means tested benefits).
It also makes sense to take advantage of the tax breaks on offer from ISAs and SIPPs. Both wrapper types allow you to invest in a wide range of assets, from funds to individual shares to investment trusts to bonds and gilts. SIPPs allow access to a slightly wider range, but unless you have very specific needs, this is unlikely to be a major factor in your decision.
So what are the most important differences?
Stocks & Shares ISAs vs SIPPs: when do you need your money?
ISAs: Money saved in an ISA can be accessed at any time, although if you’ve taken out a fixed term cash ISA an interest penalty could apply. Some ISA accounts are now flexible, which allows you to withdraw and replace money. If your ISA account is flexible and you need short term access to your savings, you can take the money out, and providing you replace it within the same tax year, you won’t lose your tax advantages. Please note that this flexible access does not apply to the new Lifetime ISA.
SIPPs: Changes to pension’s rules have made pensions more flexible than they once were – you no longer have to buy an annuity with your pension pot, and from April 2015 everyone will be able to make ad hoc withdrawals while keeping the remainder invested.
However, you still cannot access your pension until the age of 55 under normal circumstances (and the minimum withdrawal age will rise in the future). So a SIPP is for retirement savings – it’s not for school fees or future mortgage deposits.
Stocks & Shares ISAs vs SIPPs: the tax breaks
ISAs: Investments held within an ISA are protected from Capital Gains tax (CGT) on any profits made, and you don’t have to pay tax on credit interest received. Interest received on Gilts, Bonds and income from UK REITs, are initially taxed, but this tax is claimed back for you by your ISA provider. There is also no further tax to pay on any dividend income. There is no tax to be paid when you withdraw your money. If you die, then your ISA becomes part of your estate for inheritance tax purposes. The Additional Permitted Subscription (APS) was introduced in April 2015 - if your spouse or civil partner had money saved in an ISA, you are entitled to invest the value of their ISA at their date of death, in addition to your own personal ISA allowance.
SIPPs: With a SIPP, you get your tax breaks upfront. When you contribute £80 to a SIPP, it is ‘grossed up’ to £100 by the government. Higher-rate taxpayers should then claim back the rest of their tax relief on their annual tax return – so a 40% taxpayer would in effect pay £60 for a £100 contribution, while a 45% taxpayer would pay £55.
Within the SIPP, investments attract no CGT or further dividend income tax. When you come to access your money, you can take 25% of the money tax-free, but the rest is subject to income tax, unlike withdrawals from an ISA.
From April 2015, if you die before the age of 75, your beneficiaries can inherit your pension pot tax free. If you die aged 75 or over, they can still inherit the pension, subject to paying income tax at their marginal rate on any income taken.
Stocks & Shares ISAs vs SIPPs: the allowances
ISAs: As noted above, you can put up to £20,000 into a stocks & shares ISA this tax year. This is ‘use it or lose it’ – it won’t roll over to the following year.
SIPPs: You can invest up to £40,000 (after tax relief) or your annual salary (whichever is lower) into your pensions this tax year. Bear in mind that this includes all pensions – so contributions made to a company pension by an employer are included in this total.
Under ‘carry forward’ rules, you may be able to contribute more than this in the 2016/17 tax year, (assuming your annual earnings cover it), as long as you have contributed less than £50,000 in any of the previous three years.
If you are a non-taxpayer, you can still put up to £3,600 (£2,880 before tax relief) into a pension (so a grandparent could save into a SIPP for a grandchild, for example).
There is also a lifetime allowance on pensions of £1m. If your pension pot breaches this level you’ll have to pay tax on the excess when you come to access it. Note that this is based on the size of your pot, rather than your contributions. In other words, if your investments perform particularly well, you may reach the lifetime limit more rapidly than someone whose investments perform poorly. So monitor this and plan ahead.
Stocks & Shares ISAs vs SIPPs: the decision
There’s nothing to stop you from holding both a Stocks & Shares ISA and a SIPP. ISAs offer great flexibility and simplicity, and the rules governing them have so far been far less subject to change than those around the pension’s regime.
With a SIPP the combination of the 25% tax-free rate, and the ability to move the point at which you pay your taxes (for example, you may be a higher-rate taxpayer while working, but a lower-rate payer in retirement), makes the tax breaks on SIPPs particularly appealing to higher-rate taxpayers. While SIPPs are perhaps for the more experienced investor, they do offer a self-select pension option.
The exact mix you choose boils down to your goals and needs. The key thing is to make sure that whatever you are saving for the future, you should be holding it in the most tax-efficient way possible and this could involve using them both.