ISA Vs SIPP – Which Is Best For Retirement Planning?

It’s the battle of the two big retirement contenders: ISA vs SIPP – which is best for retirement planning? Financial expert Michael Barton explains their similarities and differences, to help you make the right decision.

A SIPP is for retirement planning, and an ISA is for other long-term investing. At least, that’s the conventional wisdom.

However, I’ve always thought that ISAs could have a place in a retirement portfolio. In this article, I’ll explain why – and you’ll discover how to decide which is best for your retirement investments.

What is an ISA?

(Individual Savings Account)

An ISA is an investment wrapper that allows you to save tax efficiently and flexibly. You can access the funds at any time should you need to. An ISA is really designed for investing for medium- to long-term goals.

You can invest in cash or stocks and shares in an ISA, and there are several types of ISA available. One of these – the Lifetime ISA (LISA) – enables you to save toward buying your first home or for retirement.

What is a SIPP?

(Self-Invested Personal Pension)

A SIPP is also an investment wrapper that allows you to save tax efficiently. However, unlike an ISA, you cannot access the funds in a SIPP until at least the age of 55 (57 from 2028).

You get tax relief on contributions into a SIPP (though there is a limit to this), which is a major advantage.

ISAs & SIPPs – Similarities & Differences

There are two major similarities between ISAs and SIPPs:

• They both give you access to a wide range of investments. You can invest in the stock market, stocks, bonds, mutual funds, ETFs, and other assets. This gives you a lot of options when creating a portfolio to align with your financial goals and appetite for investment risk.

• The income and growth of the funds you hold in an ISA or SIPP grow free of income tax and capital gains tax.

However, while they may be cousins in the world of investments, they aren’t identical twins. There are some key differences:

• The amount you can invest in ISAs in any tax year is limited to £20,000, though you can invest in a range of ISAs (Cash, Stocks and Shares, LISA, and Innovative Financial ISAs).

• You can invest up to 100% of your income in any tax year into a SIPP, with a limit of £60,000 (for tax relief). This includes personal contributions, employer contributions, and tax relief.

• You receive tax relief on the contributions you make into a SIPP. There is no tax relief on contributions into an ISA, though the government does pay a 25% bonus on contributions to a LISA, to a maximum of £1,000 per tax year.

• You can withdraw funds from an ISA at any time. You can only withdraw funds from a SIPP at the age of 55 (which is rising to 57 in 2028) – when you can also withdraw up to 25% of your SIPP as a tax-free cash lump sum.

• Withdrawals from an ISA are free of tax.

ISA v SIPP – Comparison Of Features

How Does an ISA Work?

You can invest in an ISA through an ISA provider or an investment platform like Wealthify or Moneybox.

You can make lump sum or regular payments into an ISA, but you cannot pay in more than £20,000 into ISA accounts in any single tax year.

There are several ISA types to which you can contribute:

• Cash ISAs – suitable for medium-term cash savings, but unlikely to produce returns that beat inflation

• Stocks and Shares ISAs – for medium- to long-term investment

• Innovative Finance ISAs (IFISAs) – allow you to invest in peer-to-peer lending opportunities

You may also contribute to a Lifetime ISA (LISA). This has been designed to help you save towards a first-home purchase or for your retirement, and comes with special rules:

• In any tax year you can deposit up to £4,000.
• The government will pay you a 25% bonus on your deposits each year (up to a bonus of £1,000 per year).
• The bonus does not count toward your ISA allowance.
• You can pay into a LISA between the ages of 18 and 50 (though you must be under the age of 40 to open one).
• You can withdraw funds from your LISA tax free after you’ve turned 60 (or earlier if using it to buy your first home).

In any tax year, you can contribute into one of each type of ISA, but your total contribution must not exceed £20,000.

You can make withdrawals at any time. When you withdraw funds from your ISAs, there will be no tax to pay. If you fill in a self-assessment tax form, you do not need to declare your ISA income/interest/withdrawals on the form.

How Does a SIPP work?

You can invest in a SIPP through a SIPP provider, such as PensionBee, Moneyfarm or Hargreaves Lansdown.

You can make lump sum or regular payments into a SIPP, and your contributions will benefit from tax relief. This means that for every £80 you contribute, £100 will be paid into the plan. Your employer can also contribute to your SIPP (depending on provider rules).

If you are a higher rate taxpayer, you can claim tax relief above 40% through self-assessment.

In any tax year, you can contribute up to 100% of your salary to a maximum of £60,000 (your pension allowance) to claim tax relief on contributions.

If you don’t earn anything in a tax year, you may still contribute up to a maximum of £3,600 (including tax relief of £720).

If you are a very high earner, your pension allowance will be reduced from £60,000 at the rate of £1 for every £2 of earnings over £260,000, to a minimum of £10,000.

You can take benefits from your SIPP from age 55 (rising to 57 in 2028, and subject to provider rules). From the age of 55 (57 from 2028) you may take a tax-free cash lump sum of up to 25% of the fund value. You can then:

• Take flexible drawdown payments from your fund
• Leave your fund to grow until you need income
• Convert all or part of your fund to an annuity

Is The ISA Or SIPP Best for Retirement Planning?

Now we’ve covered the basics, you can see that there are some striking similarities between ISAs and SIPPs, and some real differences.

Because of the way in which SIPPs work, these are probably going to be best for you if you are investing for your retirement. The upfront tax relief can make a real difference when it comes to the returns you might make – because you are investing more early on, and this also benefits from compounding.

Here’s an example of how monthly contributions of £333.33 per month over 40 years would compare, given an annual net growth rate of 5%:

As you can see, because of the effect of tax relief, your fund in 40 years could be almost £100,000 more than investing in an ISA with the same parameters.

However, if you invest in a LISA, you should benefit from a retirement fund the same amount as you would in a SIPP – but any income you take from it would be tax free, whereas the income from your SIPP would be tax liable.

So, Is a LISA Better Than a SIPP for Retirement Planning?

On the face of it, investing in a LISA is better than investing in a SIPP. However, it then depends upon your financial goals. You must remember that:

• You cannot access the LISA until you are 60. If you do, you’ll be liable to 25% tax on any withdrawal you make. Ouch!
• You can access the benefits of your SIPP from age 55 (57 from 2028).
• You can take a tax-free cash lump sum from your SIPP from the age of 55 (57 from 2028).

For the ease of calculation, I’ve considered the growth on the funds with the ISA and SIPP at 5% per year.

You should also consider the fund management fees – a fee difference of the smallest amount can make a big difference to the outcome over time, and the longer you invest, the bigger the difference will be.

So, Is a SIPP Better Than an ISA for Retirement Planning?

For most people, if your goal is to invest only for your retirement, a SIPP is the most tax-efficient way to invest. You’ll also have access to a pot of tax-free cash earlier, and have flexible options to create an income in retirement from the remaining fund.

There’s something I don’t like about SIPPs though. First, it’s the longevity of them. You’ve put all this money away, but you can’t withdraw any of it – at least, not without taking a big tax hit that blows away the tax advantage.

Second, who knows how much the government will tax you when you reach retirement? While it’s unlikely that income tax will rise, I wouldn’t put it past any government to alter the tax dynamics in our economy.

Is there an answer to this conundrum?

An Alternative to a Focus on SIPPs for Retirement Planning

You like the flexibility of ISAs, but want to benefit from the tax relief on pensions. You don’t want to miss out on the extra 25% contribution on your personal contributions.

After all, it’s not every day that the government gives you something back (as a friend of mine used to say, ‘Expect a government handout only on February 29^th, but not in a Leap Year’).

So, what if you followed this retirement planning strategy:

• Invest in Stocks and Shares ISAs every year.
• Keep your finances under review.
• As you near retirement, redirect your ISA investment to your SIPP.
• Benefit from tax relief on your contributions into your SIPP.
• Maximise your contributions into your SIPP (and tax relief on them) by withdrawing from your ISA and depositing into you SIPP every month – more tax relief and using your ISA to replace your pension contributions with tax-free income!

Would this work out better for you?

Let’s say that you contribute £333.33 per month into an ISA between the age of 27 and 47. Here’s how the two investments might compare:

Now, at age 47, you decide to contribute to a SIPP instead of ISAs. You also decide to withdraw the £135,293.51 from your ISA over the next 10 years – around £13,500 per year, or £1,125 per month.

You’re going to use this to fund your current lifestyle, and increase your personal SIPP contributions by the same amount. Here’s what happens in the next 10 years:

Doesn’t look so good, does it.

But wait… because we haven’t factored in the growth on your depleting ISA fund. If this is the same 5% as we are factoring in throughout this example, you’ll still have £46,681.95 in your ISA.

Thus, your grand retirement fund total using an ISA to SIPP strategy as in this example would be £328,127.64 versus £326,214.74. A small win, but now look what you could do at age 57:

A little bit of creativity in your retirement planning, and you’ve created a fund that pays you more tax-free cash and will produce a bigger pot from which you can create income when you need it.

Here’s Your Curveball!

Just when you think you have it all sorted, with a definitive strategy to maximise your tax-free cash and retirement income plotted, here I am to throw you a curveball. But this is a good one.

If you’re like most people who work in the UK today, you’ll have access to a workplace pension. This is your path to retirement bliss, because you get to benefit from what I call ‘free money’.

How much free money depends upon your employer, but it can be extremely lucrative.

A workplace pension is provided by your employer (typically through a pension provider). It works very much like a personal pension, with some differences. One of these is that the minimum contribution into the scheme is 8% of your salary, made up as follows:

• Your employer must pay at least 3% into the scheme
• You must make up the difference
• You receive tax relief on your contributions

So, if your employer contributes 3%, you’ll pay 4% and the government will pay 1%. Let’s say your salary is £25,000:

• You contribute £1,000 per year.
• Tax relief adds another £250.
• Your employer will pay £750 per year.
• Your gross contribution will be £2,000 per year – doubling your contribution. Money for nothing!

Many employers contribute more than the minimum 3%. Some will contribute double your contribution. If you earn £25,000 a year, and you pay 6% into your workplace and your employer pays in 12%, here’s how your gross contribution stacks up:

• You contribute £1,500 per year (£125 per month).
• Tax relief adds another £375 per year (£31.25 per month).
• Your employer contributes £3,000 per year (£250 per year).
• Your gross contribution will be £4,875 per year (£406.25 per month) – an incredible £3,375 per year of free money!

Now compare this level of contribution over 30 years across ISAs, SIPPs, and workplace pensions, with a net 5% growth rate of funds:

The Final Analysis

If you are investing toward your retirement, investing in a SIPP should grow to a bigger value than investing in an ISA. That’s thanks to tax relief. Over time, this tax relief really builds up, especially with the effect of compounding returns.

However, you won’t be able to access your funds should you need to, which is where ISAs come into play. Typically seen as a wrapper for medium- to long-term investments, it is possible to build a retirement planning strategy around ISA investment.

To do this, you’ll need to stay abreast of rules and regulations, be disciplined in how you invest, and resist the temptation to withdraw money.

There is also the question of whether you should invest in a LISA instead of a SIPP. The downside is that you cannot access funds until you are 60 (unless it is to buy your first home).

You also cannot invest as much as you like into a SIPP. On the other hand, any funds you withdraw from it will be tax free. I don’t know about you, but I love the idea of tax-free income!

Deciding how you should invest for retirement needs thorough reflection. If it’s a choice between ISAs and SIPPs:

• ISAs give you more flexibility (and, with careful planning, you can benefit from switching investment to a SIPP later).

• A LISA gives you the benefit of tax relief on contributions (at an effective rate of 20%), though the amount you can contribute is limited and the age restriction for withdrawal of funds could be a barrier for you. Withdrawals are tax free.

• A SIPP allows you to benefit from tax relief on your contributions, and access to a pot of tax-free cash from age 55 (57 from 2028). However, income taken from your SIPP will be tax liable.

While a SIPP is the best single choice for investing toward retirement, you should not rule out a blended approach, using ISAs to retain greater flexibility and access to tax-free withdrawals.

But, all this said, your first port of call when investing toward retirement should always be a workplace pension if you have access to one – the free money element makes it irresistible.