SIPP vs ISA: this time it's personal (finance)
‘SIPP vs ISA’ sounds like the least anticipated staredown sequel in the ‘Alien vs Predator’ series but I assure you it’s vastly more important to your financial health and honestly, about as easy to follow.
Both are accounts designed to help you save. Both give you access to the stock market. Both are built around tax efficiency (to help you keep more of your investment gains). And both have limits to how much you can put in every year.
But it’s the differences that will help you decide which one is best for your individual goals.
It might be that you end up favouring one over the other, or opt for both, but it all starts with understanding what each of them does - so let’s get the basics covered first.
An individual savings account (ISA) gives you the chance to save a certain amount every tax year (April to April) and makes sure that any gains you make aren’t going to be gobbled up by the taxman.
You can currently contribute up to £20,000 in the 2021/22 tax year.
As its name suggests, once that money is in your stocks and shares ISA, you can start to buy… well… stocks and shares, as well as other assets connected to the stock market like investment trusts.
This is why you’ll often hear ISAs and self-invested personal pensions (SIPPs) described as ‘tax wrappers’, because they’re just the containers - you get to choose what filling you put in them.
Stocks and shares ISAs are a great way to invest, knowing that you can keep every penny you make along the way.
Another advantage is how flexible they are. You can sell and withdraw your investments whenever you need the money, making ISAs really useful for any savings goal you have up until retirement, and maybe beyond.
The key point is that your money isn’t locked up - you decide when enough’s enough.
You can only have one stocks and shares ISA with one provider each tax year but there’s nothing to stop you from transferring your ISA account to another provider if you find a new one that’s maybe cheaper or has a range of assets that better suits you.
SIPPs work very similarly to ISAs. They let you decide what you invest in and, as the name suggests, are geared towards helping you fund your retirement.
Most other pension plans aren’t like this as they involve you handing over your money to a company that will decide how to invest it on your behalf or only offer a limited range of investments to choose from.
SIPPs are particularly useful if you have a few pensions from previous employers knocking around, which you can consolidate under one SIPP account -see here how you can transfer your pension to a SIPP.
Young people today are expected to have around 14 different pensions by the time they retire so Marie Kondo-ing them altogether in one place looks set to become even more useful.
Just remember that, while ISAs remain flexible throughout your life, SIPPs can only be accessed when you reach the age of 55.
SIPPs have contribution limits too. They are a little more complex than the ISA limit but in general most people can contribute tax efficiently up to the lesser of annual earnings and £40,000 each tax year.
However, beware if you are a high earner e.g. above £200,000, as the £40,000 allowance may be reduced to as low as £4,000. You can also be limited to £4,000 if you have already accessed income from any pension scheme.
And the way they help you save tax efficiently works a bit differently too.
When you pay into an ISA it’s normally from the money landing into your bank account at the end of each month - after you’ve been taxed.
The difference with a SIPP is that your contribution receives basic rate tax relief which is collected by the pension provider directly from HMRC and added on to your own contribution.
So, if you contribute £80 your pension provider will collect £20 from HMRC making your gross contribution £100.
If you pay tax at a rate higher than the basic rate of 20% you can get even more tax relief on your contribution paid directly to you via your tax return.
For example, if you pay income tax at 40%, your £80 contribution is boosted to £100 by basic rate tax relief being added to your pension and you can claim a further £20 back via your tax return.
Therefore the £100 going into your pension will end up only costing you £60.
So SIPPs win the attractiveness award when you put money in but what about when you want to take it out and spend it?
Well, because the money in your ISA was already taxed before you put it in, any investment gains on the way out aren’t taxed.
And you guessed it, because you got tax relief on the money going into your SIPP, tax rules apply when you withdraw it.
You can take 25% tax-free as a lump sum - something a lot of people use to clear the mortgage or pay for a child’s wedding - and then you’ll pay your personal rate of income tax on the remaining 75% as and when you draw it.
Your ISA pot can grow as big as it likes but with pensions, if the benefits you take from all of your pension pots exceeds the Lifetime Allowance, which is currently £1.0731 million and increases each year in line with inflation, you will be taxed on the excess at 25% (plus income tax) if you take it as income or 55% as a lump sum.
As we covered earlier, you can treat these accounts as shells to fill with a wide range of investments.
This means the accounts themselves aren’t inherently risky - it’s what you put in there that will determine your overall risk level.
But the ‘flexible vs long term’ nature of the comparison does throw up an interesting discussion around risk.
Normally, young savers with a super long time horizon ahead of them can accept more risk, as the ups and downs of the market will start to look less spiky the longer you stay invested.
The way Earth looks lovely and round from afar, and more jagged up close.
So, if you have 30 years until you retire and are choosing assets for your SIPP, you might end up adopting an entirely different approach to risk than in your short-term house deposit-focused ISA.
When it comes to the investments themselves there aren’t many limits on what you can hold in a SIPP or an ISA.
Some of the things you can hold include shares, bonds, investment trusts, ETFs and mutual funds.
The combination is up to you.
The range of investments available via stocks and shares ISA products and SIPP products on the market are broadly the same but there are some specialist SIPP products available that do allow alternative investments such as commercial property and unquoted shares.
SIPPs have a big potential advantage of being passed on free of inheritance tax to any nominated beneficiary and free of income tax as well if you die before the age of 75.
With ISAs, other than for spouses and civil partners, the benefits will form part of the deceased person’s estate and could be subject to inheritance tax.
Hopefully the way these accounts are set up to help us save is getting a bit clearer.
An important question right about now would be “which one is right for me?”
And to that, we can say it doesn’t have to be a choice of one or the other.
If you are looking to build up that nest egg for after you finish work, a SIPP helps prevent the temptation to dip into your savings, because you can’t.
It also essentially rewards you with ‘free money’ at the start - never a bad prospect.
For me one of the most useful aspects is the ability to tidy up all those loose pensions into one place.
Start a new job? Whack the old employer’s pension into your SIPP and carry on.
You’ll need to look at the terms of the pensions you currently hold to see if there’s anything that stops this being attractive, or even possible, but the general idea holds true.
But if you have some nearer-term goals like school fees or a house deposit you’ll need flexibility.
That’s where the ISA wins hands down.
A combination of the two, working side by side with different objectives in mind, can be a great compromise.
After all, the glory of compounding only kicks in when you give all your accounts the time they need to build up that momentum.
So having them work alongside each other as opposed to one after the other makes sense.
Learn more about SIPPs and ISAs with our guides:
- The (more realistic) ISA millionaire
- 2021 ISA income investing
- ISA the lowdown - FAQs on ISA answered
- How to invest in stocks - beginner's guide
Important information on SIPPs
SIPPs are a pension product designed for people who want to make their own investment decisions. You can normally only access the money from age 55 (set to rise to 57 from 6 April 2028).
This article is based on current rules, which can change, and tax relief depends on your personal circumstances. When you invest, your capital is at risk.
The value of your portfolio can go down as well as up and you may get back less than you invest.
Before transferring a pension you should ensure you will not lose valuable guarantees or incur excessive transfer penalties. Pensions are usually transferred as cash so you will be out of the market for a period.
Freetrade does not currently offer drawdown products for our SIPP.
This should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice.
When you invest, your capital is at risk. The value of your portfolio can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future results.
Eligibility to invest into an ISA and the value of tax savings depends on personal circumstances and all tax rules may change.
Freetrade is a trading name of Freetrade Limited, which is a member firm of the London Stock Exchange and is authorised and regulated by the Financial Conduct Authority. Registered in England and Wales (no. 09797821).