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Should you choose a SIPP or an ISA for your retirement?

The economic conditions brought about by COVID-19 have prompted many of us to consider our financial futures. The pandemic has posed severe challenges to businesses and investors alike, with financial problems near the top of the list for everyone. As ever, one consideration long-term savers need to make is the choice between various retirement options. Under the current economic conditions, the choice between a SIPP and an ISA has become more relevant and necessary than ever before.

In a nutshell, both a SIPP and an ISA are excellent options that help individuals build a pot of money for their retirement and protect their savings from heavy taxes. Both SIPPs and ISAs have several advantages, including tax-free returns and a breadth of portfolio options to invest in. However, they differ in many ways, like how accessible the fund is, for example. Ultimately, a SIPP offers perks that an ISA doesn’t, and vice versa. A combination of the two, however, can be an efficient way to manage both medium-term and long-term savings. 

What is a SIPP?

A SIPP or a self-invested personal pension plan is a tax-efficient way to save money for retirement. It allows the UK residents to take control of their investment decisions and choose what they want to do with their pension fund. A SIPP enables you to invest a part of your pre-tax income in asset types of your choice and make investment decisions flexible.

A SIPP is usually chosen by people for its flexibility and tax-efficiency. Part of the savings made by a SIPP are tax-free. A UK resident who pays the basic 20% tax on their earnings can make contributions towards a SIPP and get an extra 20% in pension tax relief. However, the tax relief is capped at contributions of up to £40,000 per financial year. Any contributions made to the SIPP beyond the annual allowance are taxed as usual. Additionally, for high-income earners above £150,000 per year, the yearly allowance drops by £1 for every £2 of excess income and can drop down to as low as £10,000.

Benefits of a SIPP

The most significant advantage of a SIPP when compared to other pension plans is its tex-efficiency. The money saved for retirement through a SIPP is tax-free up to the limit of the annual allowance. Additionally, the withdrawal of the first 25% of the lump sum is also tax-free.

Another critical benefit of SIPPs is their flexibility and ability to manage risk through diversification. Holders get to decide between different avenues of investment and choose the asset types they want to invest in. When controlled by an experienced wealth manager, they can prove to be highly profitable accounts. 

If you die, the SIPP benefits transfer to your nominated beneficiary, either as a lump sum or as an ongoing fund. A noteworthy advantage of a SIPP is that death benefits are not subject to inheritance tax and, if you die before the age of 75, there is no tax liability.

Drawbacks of a SIPP

The significant drawbacks of the SIPP lie in its withdrawal process. Firstly, the savings in a SIPP are locked in for an extended period, and the entire withdrawal is not tax-free. The first 25% of the uncrystallised fund pension lump sums can be withdrawn tax-free, but the remaining 75% remains subject to income tax deduction at source. Therefore, if not managed efficiently, individuals may end up paying a lot of money in taxes and eating into their savings. Additionally, the tax-savings on SIPP contributions are also capped with the annual allowance limit.

What is an ISA?

An ISA or the Individual Savings Account is another tax-efficient way of saving money for medium-term life goals. ISAs allow individuals to save in cash or invest in stocks and shares and withdraw the returns without paying any tax on them. The government allows people to save up to £20,000 per year in ISAs of different types, including Cash ISA, Stocks and Shares ISA, Lifetime ISA, and Innovative Finance ISA.

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While the other types of ISAs are more suitable for short-term and medium-term financial needs, Lifetime ISAs are best-suited for buying a home or retirement. Individuals can save in cash or investments through their Lifetime ISA and add up to £4,000 per year until they’re 50. The government tops up the saved amount with a 25% bonus – £1,000 a year. 

Benefits of an ISA

The most significant advantage of an ISA is its flexibility. ISAs offer versatility both in terms of withdrawal and investment decisions. There is generally no lock-in period for ISAs and savers have instant and full access to their money. Furthermore, you don’t lose on the tax benefits for the remainder of your savings if you make a partial withdrawal. Depending on the type of ISA, the withdrawn money can also be returned to the account within the same tax year.

Additionally, all types of ISAs provide tax benefits. There is no tax on withdrawal of money from cash ISAs, and there is no capital gains tax on profits earned through shares and stocks ISAs. ISAs also offer the benefit of no tax on dividend income and no tax on interest earned on bonds. Thus, ISAs work as tax-efficient modes of saving in cash as well as investing in stocks and bonds.

The other benefits of an ISA include a wide range of investment options, the ability to transfer between providers without losing the accrued ISA status, no age restrictions, and the ability for it to be inherited by your spouse. It is critical to note that if you die, your ISA will remain open for a limited period. During this time, no additional contributions can be made, but the account can continue to grow and retain its tax benefits. The funds are subject to inheritance tax, like any other asset, and are transferred to your beneficiary or administrator.

Drawbacks of an ISA

Contributions to an ISA are limited to the annual allowance of £20,000 per year, and the unused yearly allowance cannot be carried forward.

Other significant disadvantages include occasionally high charges and commissions, as well as the inability to offset losses incurred in a stocks and shares ISA by capital gains on investments outside of ISA. Investments made through ISAs are subject to volatility and market movements and, therefore, the total investments can fall in value. This is why it’s vital that, for an ISA to grow to the best of its ability over an extended period of time, it is best to entrust the management of the ISA to an experience wealth manager. 

Difference between a SIPP and an ISA

Both the SIPP and the ISA are tax-efficient ways to save for the future and for retirement. However, both products are very different and differ in some important ways. The differences should make it easy for you to decide which is more applicable to your personal situation: 

    • Tax on withdrawals: The first 25% of the funds in a SIPP can be accessed as the tax-free pension commencement lump sum, but the withdrawal of remaining funds from the SIPP is subject to income tax. On the other hand, the funds from an ISA can be withdrawn any time without any tax liability, except for the Lifetime ISA. Any money withdrawn from a Lifetime ISA before the age of 60 – unless it’s to be used to buy a first home or to pay for medical expenses for terminal illnesses – is subject to a penalty charge of 25%.
    • Minimum holding period: There is no minimum holding period for funds in an ISA. They can be withdrawn at any time and at any age. However, the money saved in a SIPP is locked in until the age of 55, and the pension pot cannot be used before that age. A SIPP is, therefore, more of a long-term investment, whereas an ISA is more suitable for medium-term requirements like a house, a car, a wedding, or your children’s university fees.
    • Annual allowance: There is no upper limit to the money that you can put into a SIPP; however, only the amount capped at the annual allowance of £40,000 per year is eligible for tax benefits. It is possible to carry forward the annual allowance of the SIPP for up to three years, while the yearly allowance of an ISA (£20,000) lapses the same financial year and cannot be carried forward.
    • Death benefits: If you die, the funds in both your SIPP and your ISA transfer to your nominated beneficiary. However, the death benefits of a SIPP are not subject to inheritance tax, and if the death of the holder occurs before the age of 75, there is no tax liability for the nominee. On the other hand, the death benefits of an ISA are liable to both inheritance tax and other taxes.
    • Investment returns: The returns on investments made through SIPPs or ISAs largely depend on the investment decisions and the choice of investment securities. However, SIPPs tend to generate a higher net return on investments due to the tax benefits of 20% on the contributions. In some cases, the savings on tax benefits may get offset by higher administration charges on SIPPs as they are more complicated to handle.

Best of both worlds

The answer to the question of whether to choose a SIPP or an ISA depends on the risk tolerance of the investor in question, along with their investment horizon and financial situation. Both SIPPs and ISAs offer tax benefits and flexibility, but they differ in terms of the minimum holding period, ease of withdrawal, and some tax implications. While a SIPP works great for long-term needs post-retirement, an ISA is an excellent alternative for medium-term financial goals.

To reap the benefits of both a SIPP and an ISA, why not simply open both a SIPP and an ISA. The combination offers the best of both worlds and helps in managing a variety of investment goals. The combined effect of a SIPP and an ISA works to optimise the tax relief for investors and maximise the returns on investments. The collaboration of a SIPP and an ISA offers the flexibility to compartmentalise investments based on specific needs and requirements and make the most of your money.

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