Thursday, 17 March 2011

ISA or SiPP? (UK)

The DIY Income Investor approach relies on shielding savings and investments from the taxman. In the UK, there are two main ways to do this:
  • an Individual Savings account (ISA)
  • a Self-invested Personal Pension (SiPP)

Tax efficiency

ISAs and SiPPs are both highly tax-efficient ways to save, since investments in each will grow free of UK income and capital gains tax (CGT). Of the two, SiPPs offer more protection from income tax.

The SiPP's main tax advantage is that it benefits from the upfront income tax relief that you receive on your contributions. However, any income that you eventually draw from a SiPP (as pension) will be taxable. You can avoid this to some extent by taking up to 25% of your accumulated investment as a tax-free lump sum on retirement.

Generally speaking, your income tax rate is likely to be lower in retirement, due to your lower income  and the higher personal allowance for over-65s.

An ISA is funded with tax-paid income - the tax benefit comes from avoiding most taxes on your investments whilst your money is in the ISA.

When it comes to investment limits, SiPPs have always been much higher than ISAs, although this difference between the annual investment limits will soon be much reduced. 

For the tax year 2011-12:
  • the Isa allowance is £10,680 (of which £5,340 can be put in a cash ISA)
  • the annual SiPP allowance is reduced (from £255,000 in the tax year 2010-11) to £50,000
A non-employed person can also pay in up to £2,880 into a SiPP and receive an additional 20% from the taxman - for nothing!: effectively a 25% instant return!

Complexity and Flexibility

ISAs are more flexible and less complex than SiPPs. You can access funds within an ISA at any time, and those withdrawals will not be subject to tax. (However, once it's out, it's out - you can only put back your annual allowance).

The main drawback with a SiPP is that you cannot gain access to your accumulated pension pot until you reach a minimum age (currently 55). Although this means that you won't have instant access to these savings, this does impose quite a strict investment discipline on you - preventing you from dipping into your savings prematurely.

Which one to choose?

Choosing between the two tax wrappers will depend on your specific situation - but, given the attractive tax relief offered by both types of savings vehicle, you should use both, if you are able.

If you are a 40% income tax payer, a SiPP is particularly attractive: you effectively will get back your 40% tax - and when you come to take your pension, you will probably only pay 20% tax on the your pension. Of course, you have to be prepared to tie up your money for a relatively long time.

If you're younger and trying to build up savings, you may be more inclined to invest in an ISA. This is also an option for saving for a non-working partner.

Keep the costs down

Whether you choose an ISA or a SiPP, the cost of the account will be an important factor in determining the return you will eventually get from your investment. The cheapest approach will always be DIY, with:

Inheritance Tax (IHT)

ISAs are not exempt from IHT, which means if you are leaving an ISA to your family, the investment will make up part of your estate and together they could exceed the nil-rate allowance (and suffer a tax charge of 40 per cent).

A SiPP sits outside an individual's estate for IHT purposes, until you begin to take income (in the form of  an annuity or draw an income directly).
