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Isas versus Sipps

Created:

10 February 2009

Written by:

Maike Currie

To invest in a Sipp or an Isa: that is the question. While each have their merits and restrictions, both are tax wrappers that determine the tax position of the investments inside the plan.

While both are long-term savings plans with tax advantages, Sipps are specifically designed for retirement savings, whereas Isas are for any form of saving. Sipps permit higher levels of savings, while Isas have an investment limit of £7,200 per tax year.

"Naturally, if inside the wrapper you hold bad funds or, alternatively, the charges are high, it does not stand that the pension or Isa is bad. Simply that the content chosen is wrong," says Peter McGahan, managing director of independent financial advisers Worldwide Financial Planning.

Both wrappers have a wide variety of investment options, but Sipps go a lot further than Isas in terms of the choice and flexibility they offer. These can include direct investment into commercial property (a Sipp can borrow to facilitate property purchase), foreign currency, derivatives, second hand endowments, hedge funds, contracts for difference, private equity, gold bullion and loans to unconnected parties, all of which Isas do not allow.

However, when it comes to the question of cash accessibility, Isas take the lead over Sipps. Isa investors have access to their money at all times, whereas you can only access your Sipp from age 50, rising to age 55 in 2010. You will then only be allowed to access 25 per cent of the pension fund value, while the rest must be taken as a monthly income. "This is often a moot point with many people," says Mr McGahan. "The lack of access is hardly motivating for you to consider saving for the next 25 years."

Tax implications

The access rules however are there to prevent people dipping into their pension fund before they need it and taking advantage of the generous tax breaks attached to a Sipp which are designed to encourage people to save for their old age. "The key benefit of a pension is undoubtedly the tax relief on the contribution at entry, which makes it difficult to warrant any other type of saving over it," says Mr McGahan. A pension contribution of £100 made by a basic tax payer only costs £78 after income tax relief. For a higher rate tax payer the net cost is £60.

"This has the effect of a guaranteed growth of over 28 per cent for the basic rate tax payer, and 66 per cent for the higher rate tax payer - the equivalent of more than 10 years in the building society, but overnight," says Mr McGahan.

To put these instant uplifts into context: should you put £7,200 into a stocks and shares Isa and it performs well, growing at 6 per cent a year after charges, it would take more than four years to get a 28 per cent uplift and more than nine years to get the 66 per cent uplift.

There are no income tax or capital gains tax implications on withdrawals from an Isa, although cash in a stocks & shares Isa carries a 20 per cent tax charge so portfolio management is important. While a Sipp can grow free of capital gains tax, income drawn is subject to tax in retirement.

However, Mr McGahan points out that Gordon Brown's decision to raise personal allowances for pensioners, during his time as chancellor, will mean that by 2011-12, the personal tax allowance will be £9,770 for an over 65-year-old, and £10,000 for someone over 75 years. This creates the opportunity to receive up to £20,000 per year, per couple tax-free from a Sipp.

Another important point in very long-term family finances is that Sipps offer tax advantages on death, which Isas do not.

In terms of inheritance tax (IHT), David Higgins, director of London-based independent financial advisers Re-Financial Planning, says that if you are leaving an Isa to your family, the investment is probably going to suffer up to a 40 per cent tax charge.

A Sipp sits outside an individual's estate for IHT purposes, but tax implications do occur once you begin to take income. If you are in income drawdown there is a 35 per cent inheritance tax and beyond the age of 75, if the investor has not bought an annuity and is not leaving the investment to their spouse, the tax on a pension fund could rise as high as 82 per cent.

"With this in mind, the investment strategy of each should be tailored accordingly," says Richard Mattison, business development director of Sipps specialist, IPS Partnership. "Sipps should be invested in such a way as to build up a fund over a long period of time which is meant to pay a pension in old age, and the investments selected should aim to achieve this. It does not necessarily mean that Sipps should only invest in low risk investments, simply that there should be a long-term game plan."

Marrying the two

Most IFAs advise that there is definitely a case for having both a Sipp and an Isa as part of your financial armoury. "While younger and trying to build up money, you can put cash into an Isa. Then at a time in the future, perhaps once your earnings have increased and you have moved a 20 per cent tax band to a 40 per cent tax band, you can encash the Isa and put the money into a Sipp, taking advantage of the 40 per cent tax relief benefit. Money can be paid into the Isa over a number of years, and, ultimately, if things don't pan out as planned, then you still have the money in the Isa which can be used at any time," says Mr Higgins.

While Sipps might be especially attractive to those in the 40 per cent tax band due to the tax relief offered, if your earnings are likely to stay within the basic tax rate band, the trigger point for moving cash from an Isa into a Sipp might simply be when you feel comfortable in committing money for a longer period of time. While both Sipps and Isas are essential to your financial planning, each individual case is different and it is impossible to have a standard approach.

According to John Moret, director of sales and marketing for Sipp provider, Suffolk Life, the average age of his company's Sipp investors is 53, a reflection, he says, that many Sipps are set up to consolidate several past pension entitlements under one wrapper. "Many of these Sipp investors will also have a portfolio of Isas. If they are in a position to do so, then transferring the proceeds of their Isas into a Sipp can make sense," he says. This will allow them, subject to the rules, to access up to 25 per cent of the fund tax free. "Full tax relief will be received on the proceeds which are treated as a contribution to the Sipp, making a reinvestment of the Isa proceeds look very attractive tax-wise provided the investor is comfortable for the other 75 per cent to be locked up in the pension."

Mr Moret adds: "Ultimately, it is horses for courses, with Isas more likely to be used by younger savers, with Sipps used later in life. However, that is not always the case and all this assumes that the tax regimes remain unchanged. There are suggestions that higher rate relief could be reduced or removed. So, anyone considering moving Isa proceeds into Sipps might be well advised to act sooner rather than later."