The Savers' Revolution: Where to invest, a SIPP or an ISA?

"Should we be putting our money in an ISA or a SIPP?" a question we hear often.

How do the products currently stand?

ISAs provide shelter from both capital gains and interest paid out, but you can now invest up to £20,000 annually. The other major difference is that the product is now more flexible - you can now switch back and forth between a stocks and shares ISA and a cash ISA.

Since April 2015, investors are no longer forced into buying an annuity which, typically offered a poor level of income. The government went further, and made pensions even more attractive by scrapping the 55% death duty tax currently levied on your pension pot after you die. This leaves even less reason to buy an annuity.

Let’s examine SIPPs first of all.

SIPP - Advantages

  • You get your tax back just for investing. The basic rate of tax is automatically added to any personal contributions. For example, if you contribute £80 the government adds another £20 to make a total of £100 (£80/0.8). Higher rate and additional rate tax payers can also claim back even more tax from HMRC on their tax return.
  • You get protection from capital gains tax.
  • You can take 25% of your SIPP as a tax-free lump sum at retirement.
  • If you die before the age of 75 you pension is passed on tax free. If you die after the age of 75 your beneficiaries will pay tax, at their marginal rate. 
  • You can now leave your SIPP to anyone, not just your spouse or a dependant, making them much more flexible.

Disadvantages

  • You can’t touch it until you retire. You must be a minimum of 55 years old (this rises to 57 in 2028).
  • When you take money out from your pension pot you are charged at your marginal rate of tax (except for the 25% tax free lump sum).
  • You are currently limited to contributing a maximum of £40,000 a year (depending on your circumstances - it could be less).
  • Your total pension pot currently cannot exceed £1,000,000, the lifetime allowance, before punitive taxation of 55% on anything you draw down above this sum kicks in (the tax is only 25% for an annuity, but then you will have to pay your marginal tax as well).
  • SIPPs are more complicated.
  • There are charges for going into drawdown.
  • Despite the recent changes, pensions are still inflexible compared with ISAs.
  • Losses cannot be offset against capital gains.

ISA - Advantages

  • Any investments inside the ISA are free from capital gains tax.
  • There is no tax on interest earned on bonds or bond funds and a 10% tax cap on income from shares or equity funds.
  • There is no need to declare your ISA on your self assessment tax return.
  • The money can be accessed any time - if you need it in an emergency or if you are saving towards a goal, for example buying a house.
  • You can pass your ISA allowance onto your spouse. For example: if you had £100,000 saved in an ISA at the date of your death, in the next tax year your spouse can save an extra £100,000 to their ISA.
  • The ISA wrapper dissolves on death and your ISA investments just become part of your estate and are subject to inheritance tax.
  • You can switch back and forth between a stocks and shares and a cash ISA depending on your investment needs.
  • Simple, flexible and easy to understand.

Disadvantages

  • You are limited to currently investing a maximum of £20,000 a year.
  • No tax relief on contributions.
  • Losses cannot be offset against capital gains.

ISA versus SIPP: where should you invest?

As is the case with all these questions, it depends on your own personal circumstances. You might think this question is most relevant to those nearing retirement, but it is also an important decision for younger investors.

Consider the following example:

  • A 25-year old invests £2,000 into both an ISA and a SIPP.
  • The SIPP sum is increased by the basic rate of tax of 20% (£2000/0.8) to a total of £2,500.
  • Both investments return 7% a year after charges.**

At the age of 65 the SIPP is worth £37,436 and the ISA is worth £29,949.

At first glance the SIPP may appear better - you will always have a larger final lump sum by investing in a SIPP versus an ISA, because of the tax relief (assuming you make the same investment in both products). However, remember that you must pay tax, at your marginal rate, on any income you take out of a SIPP, whereas income from the ISA is not subject to further tax. The major benefit to the SIPP is that you can take a 25% tax free lump sum on retirement.

The new flexible drawdown option announced in the budget (due to come into effect next April) gives investors much more freedom and control over their SIPP when they come to take money out. The 25% tax-free lump sum means that, in most cases, you will be better off with the SIPP, even after accounting for paying the tax to take income out. One notable exception is when you move into a higher tax band when you retire. In this case, you might pay more income out when you retire versus what you received from the government when you paid into your SIPP in the first place.   

One disadvantage of the SIPP, particularly when you're young, is that it locks your money away until retirement. Nevertheless, I hope the example above shows how important it is to start investing, no matter which vehicle you use. For those still in doubt, I would encourage you to read my previous article on compound interest.

Let us now consider ISAs versus SIPPs for older investors. Unlike younger investors, older investors at or nearing retirement, will be able to access their money sooner. In most cases, the combination of the tax relief when you invest and the 25% tax-free lump sum when you draw down, might make a SIPP a better choice versus an ISA. However, it will depend on your own personal circumstances, and investors must be careful how they draw down their money to avoid paying too much tax in one go. You should also be aware that SIPPs will typically come with extra charges when you enter drawdown. so this should be factored into any decision.

I will also add one important caveat: as we have recently seen, the government can change the rules at any time. We might have a new government next year and a new set of laws. Investors should prepare themselves for any scenario as best they can. With this in mind, we continue to like investing in both products, but you must ultimately decide what is best for you. If you're in any doubt, seek expert advice. 

Conclusion

ISAs have been incredibly popular and remain a great tax-efficient and flexible product for savers. However, there is no doubt that Osborne's revolutionary changes have made investing in a SIPP look much more attractive than before. Long-term investors may want to consider investing more into their SIPP. Chelsea has recently launched the Cofunds SIPP, via the Chelsea FundStore, a low-cost, execution-only product designed to make investing in a pension as simple as possible. Any decision you make should be carefully considered.

By James Yardley, research analyst, Chelsea

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. James' views are his own and do not constitute financial advice.

*http://www.bbc.co.uk/news/business-29408928
**Chelsea internal calculator

Published on 24/08/2017