You can contribute to an individual savings account (Isa) and a self-invested personal pension (Sipp) in the same tax year, but your financial circumstances may dictate that you can only afford to invest in one of the two vehicles. If that's the case, which should you choose?
Tax efficiency versus flexibility
Isas and Sipps are both highly tax-efficient ways to save, since investments in each will grow free of UK income and capital gains tax (CGT). Of the two, Sipps are the more tax-efficient, but Isas are more flexible and less complex.
The Sipp's superior tax effciency is largely down to the upfront income tax relief you receive on your contributions (see the table below). While the income you eventually draw from a Sipp will be taxable, this is mitigated by the fact that 25 per cent of your accumulated wealth can be taken as a tax-free lump sum on retirement. Also, your income tax rate is likely to be lower in retirement due to your income falling and the higher personal allowance for over 65s (currently £9,490).
But the drawback of a Sipp is that you have no access to your investments until you reach pension age - currently 55. Younger investors who may need instant access to their savings are often put off by this restriction. However, the counter argument is that this does impose investment discipline and prevents you from dipping into your savings prematurely.
You can access funds within an Isa at any time, and those withdrawals will not be subject to tax.
Marrying the two
When it comes to investment limits, Sipps have always had the upper hand over Isas. Although there is still a sizeable difference between the amount you can put into an Isa in one year compared with a Sipp, the difference between the investment limits will soon be shrinking. For the current tax year (2010-11), the annual Isa allowance stands at £10,200, of which £5,100 may be used for a cash Isa. The Isa allowance for 2011-12 is £10,680 and £5,340 of that can be put in a cash Isa. The annual Sipp allowance is falling from £255,000 in the current tax year to £50,000 in 2011-12.
Choosing between the two tax wrappers will ultimately depend on what is most appropriate for your specific situation but, given the attractive tax relief offered by both vehicles, you should use both if you are able.
If you're younger and trying to build up savings, you may be more inclined to invest in an Isa. Then, some time in the future, perhaps once your earnings have increased and/or you have moved from being a basic-rate taxpayer to a higher-rate tax band, you can move your investments from an Isa to a Sipp, taking advantage of the higher-rate tax relief. Of course, the proviso is that you are comfortable locking in your money for a longer period of time.
Remember cost and taxes
Regardless of whether you choose an Isa or a Sipp, cost is an important factor in determining the return you will eventually get from your investment. (See our funds article this week on the Isa charges of different brokers.) Whether you start to save into an Isa or a Sipp, consider using a fund supermarket. The cost savings are considerable and the long-term management of your savings is much easier as they are all under one roof.
Also remember that Isas are not exempt from inheritance tax (IHT), which means if you are leaving an Isa to your family, the investment will make up part of your estate and could suffer a tax charge of 40 per cent.
A Sipp sits outside an individual's estate for IHT purposes. However, once you begin to take income from a Sipp, tax implications do occur which vary depending on your age and whether you buy an annuity or draw an income directly.
| Comparing Isas and Sipps | ||||
|---|---|---|---|---|
| Investor tax rate | Fund held outside tax wrapper* | Stocks & shares Isa | Sipp** | |
| Pre-retirement | Post-retirement | |||
| 20% | 0% | £22,312 | £23,613 | £29,516 |
| 20% | 20% | £22,312 | £23,613 | £25,089 |
| 40% | 20% | £18,279 | £23,613 | £33,452 |
| 40% | 40% | £18,279 | £23,613 | £27,548 |
| 50% | 40% | £16,668 | £23,613 | £33,058 |
Source: Hargreaves Lansdown
Notes: This comparison shows the value of a £10,200 investment after 25 years, assuming investment growth of 6 per cent a year after charges. All values are in today's terms assuming 2.5 per cent inflation.
*Based on 80 per cent invested in equity funds and 20 per cent invested in fixed-interest funds, with no deduction for capital gains tax.
**Based on 25 per cent tax-free cash plus the remaining capital value taxed at a flat rate.
