Ask ii: should I use a SIPP or ISA to boost my retirement savings?

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A reader asks: “I’m almost 64, and still intend to work for a few more years.

“If I have enough cash to invest, and have sufficient liquid assets if needed, does it make sense to pay into my self-invested personal pension (SIPP) as much as the annual allowance allows me rather than into an individual savings account (ISA) for the better tax advantage?”

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Craig Rickman, personal finance editor at interactive investor (pictured above), says: Whether to invest hard-earned savings into a SIPP or an ISA is a conundrum many investors face.

While both are popular tax wrappers - which means they wrap around your investments to shield them from any tax on growth or dividends - there are some key differences between how SIPPs and ISAs are taxed and when the money can be accessed. It’s crucial for investors to be aware of these before ploughing lump sums into either.

The reader says he has held enough money back to cover emergencies, which is essential before investing for the long term. A figure of three-to-six months' expenditure in any easy-access account should do the trick.

So, what does the reader need to consider here? I can’t give any personal advice, but what I can do is compare the various features of SIPPs and ISAs to help them arrive at the most suitable choice.

How do SIPPs and ISAs compare with income tax?

Although SIPPs and ISAs protect any growth from capital gains tax (CGT) and dividend tax, how they are treated for income tax differs.

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As the reader notes, the tax advantages of SIPPs (and pensions more generally) typically trump those offered by ISAs. Put simply, saving into a pension has the largest benefit when tax relief on the way in (contributions) is greater than the tax paid on the way out (drawdown).

So, what is the income tax position with SIPPs? Well, contributions (within certain limits which I cover later on) receive basic-rate tax relief at source in the form of a 25% government top up. So, a lump sum payment of £10,000 is immediately boosted to £12,500.

For those who earn enough to pay either 40% or 45% tax, could (in the example above) claim back a further £2,500 or £3,125, respectively, via self- assessment – a significant tax saving.

However, when the time comes to draw from a SIPP, investors can normally take 25% of the total fund tax free, while the remainder is added to other income and taxed at their marginal rate.

When investing into an ISA, the income tax position reverses. Although there is no upfront boost available (except the Lifetime ISA which the reader is ineligible for as he’s older than age 39), the money can be drawn tax free and without any tax penalty.

This means that for 40% and 45% taxpayers, the income tax advantages of paying into a pension are significantly better than ISAs, provided future withdrawals stay within the 20% tax band.

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For workers who pay basic-rate (20%) tax, a SIPP is still more advantageous from an income tax perspective provided they use the 25% tax-free cash facility when taking benefits.

When can money be drawn from a SIPP or ISA?

With a SIPP, the earliest the money can be accessed is age 55 (rising to 57 in 2028). As the reader is 64 years old, this isn’t a problem for them.

Any ISA investments can be accessed at any point, though those opting for the stocks and shares version should be prepared to invest for at least five years to smooth out the inevitable stock market ups and downs.

What are the investment limits?

The annual limits for both SIPPs and ISAs are generous and offer plenty of scope for investors to build a nest egg.

Anyone aged over 18 can pay up to £20,000 into ISAs every year, though unused allowances can’t be rolled over.

In contrast, most investors can contribute the lower of £60,000 or 100% of earnings into a pension every year, such as a SIPP, and get upfront tax relief. This is called the annual allowance.

I say most investors because if you earn more than £260,000 a year or have already started to make taxable withdrawals from a SIPP, annual tax relievable payments may be restricted to £10,000.

These limits are known as the tapered annual allowance and money purchase annual allowance (MPAA), respectively.

Investors can potentially carry forward unused allowances from the previous three tax years, so someone could contribute more than the £60,000 annual allowance provided they have the earnings to support it. However, carry forward can’t be used by those hampered by the MPAA.

While neither SIPPs nor ISAs impose a lifetime limit on how much your investments can be worth, the maximum tax-free cash you can draw from a pension is capped at £268,275. This somewhat odd figure is 25% of the previous lifetime allowance, which was £1,073,100.

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This means that once total pension savings exceed £1,073,100, the income tax advantages of paying into a pension become less generous as there is no further tax-free cash entitlement to accrue.

What about inheritance tax?

There are some important distinctions to be drawn between SIPPs and ISAs when it comes to the dreaded inheritance tax (IHT), which this might be a consideration for anyone with an IHT problem.

One of the main attractions of pensions is that they are usually deemed outside of the estate and are therefore exempt from IHT. However, if death occurs after age 75, whoever inherits a SIPP may pay income tax at their marginal rate on any lump sums received or withdrawals taken.

Contrary to this, ISA money is considered part an individual’s estate on death and so could be subject to IHT at a hefty 40%, unless the money is passed to a spouse or civil partner as such transfers are exempt. 

In this instance, the ISA's ongoing tax-free status can be retained under what's called an additional permitted subscription (APS), which is a temporary extra ISA allowance.

So for example, if someone passes on £100,000 in ISAs on death, the surviving spouse will have a total allowance in the tax year in question of £120,000 (the APS plus the standard £20,000 limit).

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There is a further legal loophole when it comes to ISAs and IHT. ISA money invested in qualifying AIM shares that have been held for at least two years can gain 100% relief from the tax. A note of caution here though; AIM shares can be volatile so investors should be comfortable with taking significant risks with this portion of their ISA.

It’s not an all-or-nothing choice…

The good news is the decision between a SIPP and an ISA isn’t binary. The reader could split a lump sum investment between both to suit their personal financial goals.

Something the reader may want to consider first is making the most of their workplace pension, especially if boosting contributions will be matched by their employer.