ISA vs SIPP - Which is The Best For Achieving Financial Freedom?

Spare cash needs a home. And ideally, that home should be a place that attracts the lowest amount of tax possible. After all, tax drag is one of the biggest impacts on how fast an investment fund can grow. The lower the tax, the bigger the pot.

Pretty simple.

In the UK, there are two main options to consider if you’re looking to invest and save tax. And honestly, they’re both pretty good. But neither of them is perfect. 

In this article we’re going to be covering the pros and cons of each. Why you should use an ISA, why you should use a SIPP, and which is the best option for you.

Want to skip all this and speak to someone who speaks fluent ISAs and pensions? Get in touch with Rosecut today for a no cost initial discussion. 

How does an ISA work?

It’s tax free, baby! 

Yeh, that’s basically it. It has one feature, but it’s a pretty bloomin’ good one. Any money that you contribute into an ISA goes in tax free, grows tax free and can later be withdrawn tax free and penalty free.

From an investment standpoint, it’s about as much of a no-brainer as you can get. So what’s the catch? Well, there isn’t one, but there are limitations on how much you can pay in each year.

The total ISA limit is £20,000 per year. 

This is the combined limit across the various forms of ISA, which include Investment ISAs (usually the one to go for) and Cash ISAs (generally a waste of time), plus a couple of more niche options, the Innovative Finance ISA (risky and debatable benefits) and the Lifetime ISA designed for saving for your first home which we also won’t cover here.

So in a nutshell, £20,000 a year can go in tax free, grow tax free and then be withdrawn tax free. If £20,000 doesn’t sound like that much, we recently wrote an article which explains how you can accumulate over £1 million in an ISA if you invest consistently over 20 years.

So if you start in your 30’s, you could have over £1 million in completely tax free investments by the time you reach your 50’s. 

Pretty compelling.

How does a pension work?

Right, first off, pensions are mega complex. There are a million (almost) different types in the UK, and a huge number of now defunct account types which are still floating around. To avoid this article becoming a 40,000 word technical guide, we’re going to focus on the main type available to people these days.

Defined contribution private pensions.

These are basically just investment accounts that have a specific set of tax rules. Within this overall category, there are also different types, such as Personal Pensions, Employer Pension Schemes and Self Invested Personal Pensions (SIPPs).

The differences between these are technical and mainly just come down to fine print details like which types of assets can be held or who the trustees are. So for the purposes of this article, we’re going to talk about private pensions generally.

Because the tax rules for all of them are the same. These can be complicated, so let's break it down to what happens when money goes in, what happens while it’s in the pension and then what happens when it’s withdrawn.

Going in

Pension contributions attract tax relief. That means you get back an equivalent of the amount of tax you’ve paid on any contributions you make. This tax relief amount depends on your marginal rate of tax, but you get Basic Rate tax relief regardless of how much you earn, even if it’s below the personal allowance.

This Basic Rate relief is paid directly into your pension fund, while Higher Rate and Additional tax relief is claimed back from your tax return each year.

Quick example.

Say you contribute £800 into a private pension. The Basic Rate tax relief is £200, because that represents the 20% tax you would have paid on income of £1,000. Essentially, it’s giving you the tax back.

This goes directly into your pension. So you pay £800 and an extra £200 is added into your account by the government.

If you’re a Higher Rate tax payer, you can then claim back an additional 20% (£200) in your tax return, but this gets paid directly to you rather than into your pension fund. Same for Additional Rate tax relief.

There are limits on how much you can pay in, which is called your Annual Allowance. This amount is the lower of your earned income in a given year or £40,000 (rising to £60,000 in April 2023), and it includes any tax relief and employer contributions.

So if you only earned £25,000 in a year, then your Annual Allowance is £25,000. If you earn £100,000, your Annual Allowances is capped at £60,000. This amount also starts to taper down once you’re earning over £240,000 a year.

While it’s in

Phew, once the money is actually in a pension, it’s far simpler. It grows tax free, just like an ISA.

Getting money out

When you come to retirement, withdrawing money from a pension is a little more complicated as well. 25% of the balance can be withdrawn tax free, and this can be taken in one lump sum or in smaller amounts over time.

The remainder is taxable, meaning that if you’re planning on using your pension to fund all of your living costs in retirement, the likelihood is that you will pay some tax on it.

ISA vs Pension

So as you can probably see, pensions are a lot more complicated than ISAs. This summary above has just scratched the surface, and there’s a reason why most people need professional advice on their pension planning.

Generally speaking, ISAs offer way more flexibility for investors. Particularly those who aren’t sure whether they will actually retire in the UK.

But, you don’t get the boost from tax relief that you get from pension contributions, and the limit is lower if you earn over £20,000.

With pensions, you can also make catch up contributions from the past three years using the carry forward rule, which can allow you to dump a decent amount in a given year if you’ve missed the last few.

Pension contributions also lower your taxable income, which can be useful if you’re earning over £100,000 and losing your personal allowance or creeping into another tax bracket.

ISAs also have the advantage when you’re looking to spend the money you’ve accumulated. You can withdraw and spend the balance tax free from an ISA, whereas pension funds are likely to attract some income tax when the time comes.

And let’s not forget the biggest difference. 

You can’t access your pension assets until you’re at least 55 years old. So if you’re in your 30’s, you’re locking that money away for a long time.

ISAs can be accessed at any time.

One final difference is that pensions are exempt from Inheritance Tax in the UK. For this reason, many financial advisors will suggest that their clients spend their other assets down in retirement, before accessing their pensions if they need them in later life.

The best approach

We’ve aimed to make this easy to understand, but the truth is that it is complicated. The best approach for most investors is to use a combination of ISAs and pensions to work towards financial freedom.

The right mix is going to depend on a large number of factors, like when you want to gain financial freedom, where you plan to live in later life and what kind of spending items you’ve got on the horizon.

But there’s some really good news in all this.

Structured correctly, there are a lot of ways to build a very tax effective investment portfolio that can help you achieve financial freedom. We’re experts at making this happen, so get in touch today to discuss the best approach to your ISA and pension investments.

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