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ISA vs Sipp: which should you pick?

Hints for making the most of significant breaks before the end of the tax year
ISA vs Sipp: which should you pick?
  • How to save thousands in taxes by using your Isa and pension allowance
  • Why tax relief can help boost your portfolio performance

There is one answer to investment’s biggest tax question: should I use a Sipp or an Isa? Both. Taking advantage of the full allowance means most people can shelter a maximum of £60,000 of annual savings from capital gains and income tax (£20,000 in your Isa and up to £40,000 in your Sipp). The money in your Sipp also enjoys tax relief at the rate you pay income tax – for now.

And when you invest that money in the stock market, the benefits quickly mount up. An investor who uses their full Sipp and Isa allowance can save many thousands of pounds in tax bills over the years compared with one saving the same amount outside of the tax wrappers 

 

As capital gains tax is only paid on crystallised gains, it can be tempting to leave your money in the market. But this only delays the issue. As Mary McDougall highlights in our comprehensive overview of the Isa tax wrapper, if you invested £20,000 every year, a stock market growing consistently at 4 per cent would carry your portfolio over the £1m mark after 28 years. But if that money was sitting outside an Isa, almost half of it would be taxable. 

And sheltering your money from the tax man is only the start of the advantages. The power of compounding means that those tax savings will have an impact on your portfolio growth. 

And even for those not blessed with the opportunity to max out their allowance every year, the Sipp versus Isa question has the same answer – make the most of both allowances. But which to prioritise? The answer to that differs depending on your personal circumstance and your stage of life. Understanding the basics can help you make the right decision. 

 

When to tax and when to spend? 

The main tax benefits from the Isa and Sipp come at different times. Your Sipp savings are tax free at the point of investment because the money added to a Sipp receives tax relief at the rate you pay income tax. This means that the after-tax cost of a payment into a Sipp is much lower than it is for an Isa and that can have a big impact on returns. 

For example, an investor who generates 4 per cent growth from an £800 annual investment in their Isa every year for 20 years will be left with a portfolio worth £25,575. The same investment in a Sipp by a basic-rate taxpayer will have tax added back, meaning £1,000 is invested every year. After 20 years the portfolio would be worth £31,969. 

The Isa wrapper comes into its own when you want to spend the money you have invested. All of the money is free of capital gains and income tax and there are no restrictions on when this can be taken, unless it's in a Lifetime Isa. By contrast, only 25 per cent of the money in a Sipp can be taken as a tax-free lump sum (although as income drawn down thereafter is taxed in the same way as a salary, you might be able to receive some income tax free) and it is only accessible from the age of 55 (this will rise to 57 in 2028 and increase in line with the national retirement age). 

For new or young investors, the temptation therefore might be to make the most of your annual Isa allowance every year and not worry about the Sipp – after all, retirement is a long way off. But the sooner you invest, the more tax you will get back from HMRC, leaving compounding to do its job on your savings. 

 

Understand your allowances

The Isa allowance is set at a fixed level every year (currently £20,000) and cannot be rolled over. Your annual pension allowance is tied to your income (you can pay 100 per cent of your annual earnings into your Sipp up to a maximum of £40,000) and contributions to a workplace pension will use some of this up. This means that you might be better off making the most of your workplace pension if the offer is generous enough. 

The pension savings you make through your workplace scheme enjoy the same tax relief as those in a Sipp and your employer is obligated to pay a minimum of 3 per cent of your salary on top of your contribution (most at least match your contribution). For this reason, it is always best to save as much as you can in a generous workplace scheme and use your Isa allowance for extra savings. 

However, if you aren’t using your full pension allowance through your workplace scheme, it is certainly worth topping it up with a Sipp. It is also worth paying attention to the pension provider used by your workplace. For example, if you are a long way from retirement and therefore able to take slightly more risk with your savings, you could be better off using more of your annual allowance in your Sipp and investing it in funds or companies that are going to make the best use of your capital. 

The same is true of defined benefit pension schemes which guarantee you an income when you retire based on your salary while you were at work. Today, it is more than likely that this will be based on your career average earnings, rather than your final salary (this extraordinarily generous pension scheme is being wound down across most of the public sector). It may be worth considering building on this guaranteed pot with a Sipp.

 

Start early to get the best of both accounts 

Prioritising your Isa and your Sipp is a personal decision that will depend on what you plan to use your savings for. As a general rule of thumb, any money earmarked for a certain purpose prior to your retirement should be saved in an Isa, other investments should go into your Sipp. 

But picking the right account matters less than saving early and often. So don’t delay – set up an Isa and a Sipp to make the most of your annual allowance for 2020/21.