How to compare an ISA with a SIPP

By: Tim Bennett
ISAs and SIPPs are both tax-effective savings vehicles. Here, Tim Bennett helps investors to weigh them up.

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How to compare an ISA with a SIPP

No-one wants to hand their money over to the government as unnecessary tax. So that makes ISAs and SIPPs pretty valuable to investors. But how do you weigh up the benefits? Here’s a short reminder.

The common ground

We should start with one important point – both ISAs and SIPPs can be very useful even if they work in different ways. Each one is a tax wrapper that sides around a wide pool of investments that can include; shares, bonds, cash and funds.
The precise way in which the tax breaks work is particular to each. Let’s start with income tax.

Income tax

With an ISA, the amount paid in is the amount then invested. Personal pensions, such as SIPPs, on the other hand give tax relief at the point money is paid in. This is given at the basic rate of tax of 20%, with more available to higher and additional rate taxpayers via self-assessment tax returns.
After that, any income earned accrues tax-free within the wrapper. When it comes to withdrawals, there is another important difference – an ISA allows the full amount to be taken out (albeit at the cost of future tax benefits unless it is paid back in within the same tax year) whereas with a pension you are limited to 25% of the fund on hitting the minimum retirement age of 55, with the rest taxed.
The following table shows how tax could work on an investment of £100, assuming growth over the life of the product, to £200. The column on the right shows the potential gain as a percentage of the amount initially invested. Pensions come out on top, in particular for higher rate taxpayers. However, the price you pay for this is a lack of flexibility over the timing of withdrawals.

Capital gains tax

Here the position is simpler and more consistent. In each case, once investments are inside the wrapper they can roll up free from tax on any gains.

Inheritance tax

Older investors need to be alert to a key difference here – ISAs do form part of a death estate and may suffer tax at 40% as a result, whereas SIPPs do not. There is a way to mitigate the IHT impact on an ISA using qualifying shares (e.g. those on AIM) but it is risky and not for everyone. It is also worth noting that the Additional Permitted Subscription rule allows the transfer of ISA allowances on death so that future income and capital gains tax protection is not lost. That all said, older savers may still be better off using up their ISA assets before drawing on a pension – this is worth a further discussion for anyone affected.

Further thoughts

Whilst tax is a big part of the equation, it is not the only factor. For example, the fact that an employer may be prepared to pay into a SIPP but not an ISA can tip the balance. Set against that, the minimum age at which you can draw from a SIPP is likely to keep rising.

Please contact an Investment Manager or Wealth Planner to discuss any of these points in more detail.