SIPP VS ISA: Which One Should You Choose for Your Retirement?

Both a SIPP and an ISA are excellent options when it comes to building a pot of money for the future. But what are the differences between a SIPP or ISA for retirement?

The economic conditions brought about by COVID-19 prompted many of us to consider our financial futures. The pandemic posed severe challenges to businesses and investors alike, with financial problems near the top of everyone’s list. As always, one consideration long-term savers need to ponder is the choice between various retirement savings options. Under the current economic conditions, making the right decision has become more important than ever. When it comes to considering retirement, which is better? SIPP or ISA?

In a nutshell, when comparing SIPPs against ISAs, both are good options that help you build a pot of money for your retirement. The advantages both SIPPs and ISAs offer include capital gains tax (CGT) free returns and a wide choice of portfolio options in which to invest. However, they differ in several ways, one of which is how accessible your funds are. A SIPP offers perks that an ISA doesn’t, and vice versa. But, rather than looking at it as a SIPP vs ISA either or, a combination of the two can be an efficient way to manage both medium-term and long-term savings.

Tax-free savings options in the UK

Most people in the UK have a personal savings allowance. For basic rate taxpayers, it’s £1,000; for higher rate taxpayers, it’s £500, and it’s £0 for additional rate taxpayers. That’s how much interest you can earn (on top of your starting savings rate) tax-free. In effect, it means that all forms of savings up to these thresholds are tax-free.

However, specific savings and investment vehicles are considered tax-free. These include SIPPs and other pensions, plus ISAs.

Calculating potential tax savings

If you’d like to find out how much money you could save by switching your savings to a tax-free account like a SIPP or ISA, there is a useful savings tax calculator on the Telegraph website. Simply enter the amount of savings you have, the interest rate being applied, and your taxpayer band. The calculator will then do the calculation for you automatically.

If the amount you could save by switching is significant, you may want to consider transferring your savings into a SIPP or an ISA.

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 UK residents to take control of their investment decisions and choose what they want to do with their pension funds. A SIPP enables you to invest a part of your pre-tax income in asset types of your choice and make flexible investment decisions.

As regards the SIPP or ISA debate, SIPPs are often chosen by people for their flexibility and tax efficiency. Part of the pension contributions or savings made to a SIPP is 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 on their contributions. However, the tax relief is capped for contributions at £60,000 per tax year. Any contributions made to a SIPP beyond the annual allowance will be taxed.

Additionally, for high-income earners above £260,000 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

As mentioned, the most significant advantage of a SIPP is its tax efficiency. Money saved for retirement through a SIPP is tax-free up to the £60k annual allowance limit. In addition, 25% of your pension pot can be withdrawn tax-free at age 55 (rising to 57 in 2028).

When considering the SIPP or ISA option, the other key benefits of SIPPs include their asset flexibility and the ability to manage risk through diversification. When controlled by an experienced wealth manager, SIPPs can prove to be highly profitable accounts.

Once you’ve passed away, the money left in your SIPP is normally passed to your nominated heirs without incurring inheritance tax (IHT), provided the fund is uncrystallised. However, the 2-year rule applies. If you expire before you reach 75, your executor must notify the SIPP provider within 2 years. If you die at age 75 or over, any withdrawals your beneficiaries make will be added to their income and will be subject to taxation.

You should keep the beneficiaries of your SIPP up to date as you do with your will. You can do this by completing an “expression of wish” form. The trustee of the SIPP will ultimately have discretion as to whom any death benefits are paid but will take your wishes into account.

Drawbacks of a SIPP

When considering SIPP or ISA, there are some significant drawbacks with the SIPP, and they lie in the withdrawal process. Firstly, the savings in a SIPP are locked in until your 55^th birthday, and then, only 25% of your pot is tax-free. The remaining 75% will be subject to income tax. Therefore, if not managed efficiently, you could pay a lot more tax. In effect, you won’t get your full withdrawal amount if it tips your total income for any tax year over your income tax threshold.

What is an ISA?

An ISA or an Individual Savings Account is another tax-efficient way of saving money for medium-term life goals. ISAs allow you to save in cash or invest in stocks and shares. Click here for a comparison between the two solutions over a 10-year period.

The biggest advantage when doing a SIPP or ISA comparison is that when you withdraw money from an ISA, you do so without paying any tax. But the ISA rules only allow you to save a maximum of £20,000 per tax-year across ISAs of different types, including cash, stocks and shares, lifetime, and innovative finance ISAs.

Most types of ISAs are suitable for short-term and medium-term financial needs, as you can draw money out at any time. However, a SIPP vs lifetime ISA analysis reveals that LISAs are best suited for buying a home or saving for retirement. You can have cash, stocks and shares, or a combination of both in a lifetime ISA and contribute up to £4,000 per year until you’re 50. The government will add 25% per tax year to your annual contribution totals. But after that, the government top-ups stop. In addition, you cannot make any further contributions. This can be significant when contemplating which is best –  lifetime ISA or SIPP.

When comparing the two savings vehicles, you also need to be aware that if you withdraw money from a LISA for anything other than purchasing your first house or taking retirement income, you’ll be penalised with a 25% tax hit. When we did our lifetime ISA vs SIPP analysis, we looked at all the complexities with LISAs and decided not to offer one.

We’ve discussed the other types of ISAs and explained the drawbacks of lifetime ISAs. The innovative finance ISA (IFISA) is another one with a drawback: the risk associated with it. IFISAs are vehicles for peer-to-peer lending, which can be inherently more risky than their stocks and shares cousins. IFISAs are also not covered by the FSCS. But what about cash ISAs? How do these figure in the SIPP or ISA debate?

Differences between cash ISAs and stocks and shares ISAs

Cash ISAs are very popular, and they are covered under the FSCS. Their biggest drawback, though, is the low interest rates they offer. It is generally no better than the interest offered on easy-access savings accounts. It means their funds will grow considerably more slowly than they would in either stocks and shares ISAs or SIPPs.

Benefits of an ISA

The most significant advantages of the ISA when doing a SIPP or ISA comparison are the ISAs flexibility and its tax-wrapping nature. Both are very important when it comes to making investment decisions.

With ISAs, you have full, fast access to your money at all times. Furthermore, you don’t pay any income tax on withdrawals. Also, if you elect for a flexible ISA, any withdrawn money can be returned to the same account within the same tax year without affecting your personal ISA allowance.

All types of ISAs (apart from the lifetime version) provide these same tax benefits. It’s a key consideration in the SIPP vs ISA debate, especially the fact that money taken out from them is not taxed. There is no capital gains tax on profits earned through shares and stocks ISAs. Stocks and share ISAs also offer the benefit of no tax on dividend income and no tax on interest earned by bonds.

Other benefits of ISAs include a wide range of investment options, the ability to transfer between providers without losing the accrued ISA status, and no age restrictions. In the battle of the tax wrappers, there is only one winner – the ISA.

Recent changes in pension savings and tax implications

There are two significant recent changes regarding pension savings and tax implications. The first came into effect on April 23, 2023, and it abolished the lifetime allowance (LTA).

The second change came into force at the beginning of the 2024/25 tax year. It increased the annual private pension contribution threshold by £20,000, so you can now save up to £60k per annum tax-free.

The ISA allowance was left unchanged at £20k per annum, which makes a notable difference when doing a SIP or ISA comparison.

Inheritance tax implications for ISAs and savings

The money held in savings and ISAs can be inherited in the usual way. It forms part of your estate. If the total value of that estate is less than £325,000, it’s free from inheritance tax (IHT). Anything above the threshold will be subject to IHT at 40%. If your estate includes your home, which is bequeathed to children (including foster and grandchildren), the tax-free estate allowance increases to £500,000.

Upon your death, ISAs can be inherited tax-free by your spouse or civil partner, provided an additional permitted subscription is issued, as discussed in the next section.

After you die, an ISA can remain open for a limited 3-year period. During this time, no additional contributions can be made, but the account can continue to grow and retain its tax benefits. It becomes what is referred to as a “continuing ISA.” The funds will be subject to inheritance tax, like any other asset, as explained above.

ISA additional permitted subscriptions

Spouses or civil partners inheriting ISAs can do so tax-free by using a one-time additional permitted subscription, or APS for short. The value of this APS will be equivalent to the value of the funds in the ISA.

The money is not paid directly to the surviving partner. Instead, their ISA allowance is increased by the said amount so that the funds can be transferred to the partner’s ISA. If your spouse or civil partner doesn’t already have an ISA, one will be opened.

If, for example, the value of the APS is £500,000, the partner’s ISA allowance for that year will be £520,000 (their own £20K allowance plus the £500K APS). This is strictly a one-off occurrence. So, when comparing the SIPP vs. ISA formats, the APS plays a significant role.

Drawbacks of an ISA

The biggest drawback of an ISA, when doing a SIPP or ISA comparison, is that, as previously mentioned, contributions are limited to the ISA annual allowance of £20,000. Any unused balance cannot be carried forward. You use it or lose it.

Other significant disadvantages can include the fact that some providers charge high fees and commissions. In addition, like most investment vehicles, ISAs are subject to volatility and stock market movements, although factors such as built-in diversity and investing long term can act as mitigating agents. However, you need to be aware that investments can fall in value as well as rise.

The other thing to bear in mind is that the ability to withdraw funds at any time is a double-edged sword. While it can help if you find yourself in a cash crisis, it also reduces the potential size of your investment in the long run.

Impact of the personal savings allowance on ISAs

The personal savings allowance (PSA) was introduced in 2016. Before its introduction, you had to pay tax on any savings you had. But the PSA allows you to earn £1,000 interest on your savings in any one tax year, free from tax. The only savings vehicles this does not apply to are ISAs. They are tax wrappers, and therefore, the money contributed doesn’t affect your PSA.

Junior ISAs and SIPPs

So far, we’ve discussed four types of ISA. However, there is a fifth, and it’s the junior ISA. It might also surprise you to know that there is a junior SIPP, too, so it raises the question – junior ISA or SIPP? Both can be opened by parents or legal guardians on behalf of a child. The child cannot assume management of the SIPP until age 18, whereas they can assume management of a JISA at age 16. It then turns into an adult ISA at 18.

When it comes to the junior SIPP vs. junior ISA debate, the main difference is that whereas with the JISA, the child can access and do what they like with the money at 18, with the J-SIPP, they either have to leave the money where it is or move it to another pension. In any event, it’s locked away until the child reaches the age of 55.

Best of both worlds

While investors should be aware of the factors above when comparing an ISA or SIPP, the answer depends on the investor’s risk tolerance and investment horizon. 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 well 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? It doesn’t have to be one or the other. Instead, combining the two options offers the best of both worlds and helps in managing a variety of investment goals. Individuals with a huge disposable income might find it beneficial to invest in both ISA and SIPP. Carefully weighing the pros and cons of SIPP or ISA and their respective tax treatments can help determine the best allocation of funds.

The combined effect of a SIPP and an ISA works to maximise the returns on investments for investors. In addition, 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.

SIPP vs ISA FAQ

SIPP or ISA? Which to choose for long-term investment?

SIPP and ISA accounts are good options for long-term investing. A SIPP and an ISA are great for longer-term goals such as retirement. They also provide some flexibility if you need extra money before you retire.

ISA or SIPP: Which to choose for retirement?

Both SIPPs and ISAs can help you save for retirement. Ultimately, the decision between a SIPP and vs ISA may come down to your specific retirement goals and your time horizon. If it’s definitely for retirement and life after age 55, then SIPP accounts are designed for you.

Should I open both a SIPP and an ISA?

You can have both, but please talk to a financial adviser if you’re not sure which option is best for you.

If you choose an ISA and SIPP combination, you can use each account to achieve different financial goals. For instance, a SIPP allows you to access your money from age 55. Also, you can withdraw 25% of your pension fund without paying any taxes. An ISA gives you access to your money at any time without paying any tax at all. It can be a great way to meet medium-term goals.

It’s important to watch for changes in savings tax rules and what they might mean for your investments. Assets can appreciate or depreciate.

SIPP or ISA: How to decide what assets to put in?

Both accounts offer a wide range of investments, including stocks, shares, trusts, bonds, and ETFs. When evaluating your options, it’s important to consider your age, financial situation, investment goals, time horizon, risk tolerance, and tax implications.

Moneyfarm provides a range of fund recommendations for different types of investors, and we also offer customised portfolios for investors who want to invest. You can also view the investment holdings of our ISA and SIPP offerings, including a breakdown of asset classes.

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