This will become evermore apparent over the coming years, as the announcement in the 2021 Budget that there will be a freeze on tax allowances until 2026 could actually prove to be a decrease in allowances once inflation is accounted for.
Investors need to therefore make the most of the available tax wrappers, and the two most notable are the Self-Invested Personal Pension (SIPP) and the Individual Savings Account (ISA), of which each offer generous tax reliefs.
But whilst there are similarities and both should be considerations for investors looking to grow their capital tax-efficiently, SIPPs and ISAs are entirely separate products with very significant differences – so where should you invest?
As with most investment products, there isn’t a one-size-fits-all answer to this. Your individual circumstances will heavily dictate where you should consider investing more of your capital and therefore it’s important to seek advice from an independent financial advisor before making investment decisions.
With that said, understanding the core fundamentals of each product sets the foundations upon which you can begin to make decisions on where your capital could be best placed.
A SIPP is a type of pension (though an ISA can be used for pension planning)
A SIPP is a pension suitable for those comfortable with making their own investment decisions – in other words, a do-it-yourself pension.
Unlike a more traditional pension, a SIPP allows investors to have much more control over where their retirement funds are invested, and affords them the ability to manage them all on an online platform.
Furthermore, the type of investments that can be held within a SIPP are often of a much broader range than you would find in a pension traditionally (or at least that you would usually find you have access to). The SIPP provider will ultimately dictate what your asset options are, but you will generally have a choice of everything from stocks and shares and Government bonds through to commercial property - and in an increasing number of instances, approval can be requested to invest in more alternative investments, such as asset-backed bonds.
When we switch our focus to the ISA, while it is possible to use an ISA to save or invest for retirement, an ISA is not a pension. Instead, it is a tax wrapper with a variety of account options suited to different saving and investment goals – retirement or otherwise.
Including the synonymous Cash ISA, a cash savings account with a low risk profile, there is also the popular Stocks and Shares ISA and the Innovative Finance ISA (IFISA), an investment product that allows investors to hold peer-to-peer loans and debt-based securities.
Providing investors with an array of opportunity depending on their risk/return profile and their asset preferences, the similarities to a SIPP at this stage are clear – however, the differences begin to become apparent when we explore the tax reliefs.
Whilst both render all returns free from income tax and capital gains tax, because of its status as a pension – and the needs for your capital to be held for what could be several decades – as an investor into a SIPP, you are rewarded with tax relief on contributions at your marginal tax rate (currently 20% for basic-rate taxpayers, 40% for higher-rate taxpayers, and 45% for additional-rate taxpayers).
For example, in order to make a contribution of £10,000 to a SIPP as a basic-rate taxpayer, you would need to subscribe just £8,000 – the Government would then pay a further £2,000 into the pension in tax relief.
With such tax relief on contributions not available to ISA holders, whilst some investors do make use of their ISA allowance to contribute towards their pension planning, it makes SIPPs a valuable consideration. However, it’s paramount to remember that as the SIPP is a dedicated pension product and the ISA isn’t, it has specific requirements that need to be met - essentially the intention to invest for a longer period, or at least have your funds unable to be withdrawn easily, regardless of how they perform.
Both SIPPs and ISAs have withdrawal restrictions – but they differ
As funds in a SIPP are meant for retirement, most do not allow you to make withdrawals until the age of 55 (though there are some exceptions in a very small number of circumstances). As well as this, you must be under the age of 75 to open a SIPP.
By comparison, most Adult ISAs do not have age-related withdrawal restrictions – other than the Lifetime ISA, which requires savers and investors to be aged 60 or over before accessing their funds, unless the money will be used to purchase their first home.
Other than this, all savers aged 16 and above are able to open and withdraw from a Cash ISA, and investors aged 18 and over can open and withdraw from an IFISA or Stocks and Shares ISA.
So, for an investor aged 30 who would like access to their capital within 10 years, investing into an ISA is the most sensible option. In fact, with a SIPP as the alternative, it’s the only option – otherwise their money would be tied within their SIPP for at least 15 years longer than they require.
It is important to note that some ISAs are fixed term, resulting in funds being invested for a set period of time. For example, an IFISA will typically have a fixed term of between two and five years, whilst a Stocks and Shares ISA often comes with the recommendation of investing for a minimum of five years, allowing time for any falls in value – due to the fluctuating nature of the stock market – to recover.
Importantly, when withdrawing from a SIPP, you are able to take up to 25% tax-free once you are 55, whilst any further payments that exceed your annual income tax allowance will be taxed accordingly. This is in contrast to an ISA, where all withdrawals are tax-free - if you had £1 million in ISA products, as an increasing number of investors that have invested each year since the ISA’s launch do, this could be withdrawn in full or part at any point and there would be zero income tax due, regardless of your financial status.
ISAs and SIPPs have strict subscription allowances that shouldn’t be exceeded
Unlike more direct investments where there is effectively no upper limit, you are only able to save or invest up to a certain amount into both an ISA and a SIPP each tax year. Called the annual ISA allowance and annual pension allowance, in 2020/21 – and 2021/2022, as the Chancellor of the Exchequer announced in his Budget on 3rd March – the former is £20,000, whilst the latter is dependent on your earnings and is capped at £40,000, though you can’t contribute more to your SIPP than you have actually earned.
Both of these allowances are generous, and using them to their maximum affords investors the best opportunity to grow capital tax efficiently.
It is worth bearing in mind that the annual ISA allowance can be split between multiple ISAs – so investors could benefit from the safety of a Cash ISA, albeit with minimal interest earned, as well as the potentially higher target returns of an IFISA or Stocks and Shares ISA.
It is imperative that both annual allowances are not exceeded, and you are responsible for ensuring this.
If you believe you have exceeded your annual ISA allowance, you must contact both the ISA provider (with which you believe the limit was breached) and HMRC on their ISA helpline. You will then be advised on what happens next, but you will not be entitled to tax relief on subscriptions in excess of the allowance.
Similarly, if you exceed the annual pension allowance, you won't receive tax relief on any contributions you paid that exceed the limit and you will face an annual allowance charge. This annual allowance charge effectively negates the value of the tax relief previously gained on the excess contributions.
Inheritance tax rules differ between ISAs and SIPPs
Another significant differentiator between an ISA and a SIPP is what happens to the product in the event of the holder’s death.
A SIPP does not form part of your estate upon death, and you are able to choose a beneficiary who will pay no inheritance tax on the SIPP if you are under the age of 75 when you die (unless they choose to take the benefit as a lump sum but do not claim it within two years).
On the other hand, if you are over 75 when you die, your beneficiaries will be required to pay income tax on your pension fund, regardless of whether they choose to take the money as an income or a lump sum.
Contrastingly, ISAs do form part of your estate upon death, so if your estate is liable for inheritance tax, this will include your ISA. As well as this, ISAs lose their tax-free status upon death, meaning the beneficiary will not benefit from tax-free income and growth.
Please note: this offers just an insight into the products and how they are treated upon death of the holder. There are complex rules surrounding SIPPs, ISAs and inheritance tax, so it’s important you seek appropriate advice if this is a consideration when investing.
Deciding whether to invest into a SIPP or an ISA
It is clear that both SIPPs and ISAs have generous tax benefits that most investors will want to take advantage of.
When deciding whether to invest into a SIPP or an ISA, it will ultimately depend on your investment goals and the timeframe in which you would like access to your funds – but keep in mind you don’t have to choose just one.
A SIPP benefits from most of the same advantages of a traditional pension, with added control and visibility for experienced investors wanting to be more hands on with their retirement fund. An ISA could potentially be an important supplement to this, but many investors use it completely independently of their pension planning to cater to their short to medium–term saving and investment goals.
Either way, utilising both products, and making the most of their individual annual allowances, results in the chance to invest up to £60,000 tax-free each year – a valuable consideration for maximising returns.
The CARLTON Bonds product is available exclusively to experienced investors who are classified as either sophisticated investors, high-net-worth individuals or professional investors and have the knowledge and experience to make their own investment decisions. Investments are high risk and illiquid, your capital is at risk and returns are not guaranteed. Bonds are not protected by the Financial Services Compensation Scheme (FSCS).