Morningstar's 'Perspectives' series features guest contributions from third parties such as asset managers, academics and investment professionals.
You can contribute to an Individual Savings Account (ISA) and a Self Invested Personal Pension (SIPP) in the same tax year, but what if your financial circumstances mean that you can only afford to invest in one of the two vehicles? If it comes down to choosing between an ISA or a SIPP, where should you invest?
Below are lists of pros and cons covering the differences between ISAs and SIPPs:
Advantages of ISAs
- For the 2012-2013 financial year, you can save up to £11,280 of which £5,640 can be held in cash.
- For the 2013/2014 financial year, you can save up to £11,520 of which £5,760 can be held in cash.
- Annual allowances will increase each year in line with the consumer price index (CPI) measure of inflation.
- The annual allowance limits give most people scope to build a decent savings pot, which could create an income stream to live on during retirement.
- All your investment returns are tax-free.
- Any income or capital gains taken out of an ISA are tax-free.
- There are no restrictions on what you can do with the money.
- You have access to your money at all times.
- You can draw a tax-free income at any time.
- The income you take doesn't need to be entered on a tax return.
- There is no limit on the size your ISA can grow into.
- You can transfer your account between providers.
- Dividends are paid tax-free minus 10% which is deducted by the issuer.
Disadvantages of ISAs
- You don’t get any tax breaks on your contributions, which you would get by contributing into a pension.
- If you're going to use ISAs as a way to save for retirement, you need to have the discipline not to touch your money before you need it.
- There is a limit on how much you can invest each year.
- You cannot claim back tax on your contributions.
- If you sell, you lose all your previous years' allowances.
- When you die, your ISA will be included in your estate and subject to Inheritance Tax.
Advantages of SIPPS
- SIPPs enforce saving discipline until retirement (since you cannot withdraw your money early.)
- You receive tax relief upfront from the government when you make contributions, which can feel like the government is giving you money to save for your retirement
- If you’re a taxpayer, you can contribute as much as 100% of your annual earnings into a pension, up to a maximum of £50,000 a year.
- All the income you receive and all your capital gains are exempt from tax.
- When you retire, you have the option of taking up to 25% of the value of your fund as a tax-free lump sum.
- SIPPs are more suited for higher-rate taxpayers.
- You can transfer your account between providers.
- You are likely to pay less tax in retirement than while you are working. This means high earners get 40% tax relief up front on their contributions but will probably only pay 20% tax on their pension income in retirement.
- When you die, your SIPP value is protected from Inheritance Tax.
- You do not have to retire from work to take benefits from your SIPP. Under current government legislation, you can begin taking benefits at any age from 55.
- From age 55, you can take your benefits in stages (both income and tax-free lump sum). This is known as phased retirement.
- From age 55, income can be taken in the form of:
1) Drawdown Pension
2) Annuity (Secured Pension)
3) Combination of Drawdown Pension and Annuity
- Flexible Drawdown will allow some individuals the opportunity to withdraw as little or as much income from their pension fund as they choose as and when they need it. (You have to declare that you are already receiving a secure pension income of at least £20,000 a year and have finished saving into pensions.)
Disadvantages of SIPPS
- Even though recently simplified, they can seem complicated for many investors.
- You get no access to your money until you are 55.
- You can only take 25% of the pension fund value directly free of tax, while the rest must be taken as a monthly ‘taxable’ income.
- There are restrictions on drawing an income in retirement. You either have to buy an annuity--and rates are the lowest they have been in years--or you draw income directly via drawdown. The GAD rate by which income drawdown limits are set has dropped to low levels.
- The maximum amount of income you can take as income is subject to government restrictions. The current capped drawdown limit is 100% but this will be raised to 120% from April 6, 2014.
- The amount of money you can build up in a SIPP is called ‘lifetime allowance’ and for the 2012-2013 tax year, this limit is £1.5 million. If your fund has a value above £1.5 million, the excess will be subject to a tax charge of 25% and a possible lump sum levy of 55%.
- The Chancellor of the Exchequer announced in his 2012 Autumn Statement that the maximum lifetime allowance amount would be cut from £1.5 million to £1.25 million.
- SIPPs are vulnerable to change. The government has become very fond of changing the rules on pensions in recent years. That means legislation could change during the period your money is locked away.
- The benefits of tax relief on contributions are largely offset by the income tax paid on pension income.
Conclusion
When looking at the difference between ISAs and SIPPs, it's important to remember that your contribution decisions should be based on your financial objectives and your own personal circumstances.
For most of us it makes sense to use both pensions and ISAs when saving for the future. The extent to which you use one over the other will depend on how you think your tax status will change over time and how much flexibility you need.
The views contained herein are those of the author(s) and not necessarily those of Morningstar. The article is based upon sources and data believed to be accurate and reliable. If you are interested in Morningstar featuring your content on our website, please email submissions to UKEditorial@morningstar.com.
For more information about ISACO, click here to download their free brochure.
