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?
Following on from our last post on this subject, we've prepared a checklist covering the differences between ISAs and SIPPs:
Advantages of ISAs
- For the 2012/2013 financial year, you can save £11,280.
- 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 anytime.
- 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 contributions.
- 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.
- You are only allowed to invest up to £11,280 (2012/13) per year currently.
- 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.
- You receive tax relief upfront. For a higher rate taxpayer, this has the effect of a guaranteed instant growth of 66 per cent.
- 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.
Disadvantages of SIPPs
- Even though recently simplified, they can be seen by many investors as complicated.
- You get no access to your money until you are 55.
- You can only take 25 per cent 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 amount of money you can build up in a SIPP is called ‘lifetime allowance’ and for the 2012/2013 tax year, this limit is £1.5m. If your fund has a value above £1.5m, the excess will be subject to a tax charge of 25% and a possible lump sum levy of 55%.
- 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.
When looking at the difference between ISAs and SIPPs, it's important to remember that the decision on which to choose will depend on your financial objectives and your own personal circumstances.
For most of us it makes sense to use both SIPPs and ISAs when saving for the future and 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.
Please note past performance should not be used as a guide to future performance, which is not guaranteed. Investing in Funds should be considered a long-term investment. The value of the investment can go down as well as up and there is no guarantee that you will get back the amount you originally invested.
If you're thinking about how to save for the future, then I hope you've found this post helpful. As always, if you have any questions or thoughts on the points covered in this post, please leave a comment below or connect with us @ISACO_ on Twitter.
ISACO was established in 2001 by brothers Stephen and Paul Sutherland and is the first financially regulated firm to offer adventurous ISA and SIPP investors a unique personal investment service that shares on a daily basis our star-performing investor’s thoughts, personal insights and investment decisions.
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