Saving for retirement: Isas versus Sipps

Sipps offer more generous tax breaks overall, but Isas are more flexible. So, which is better? Cris Sholto Heaton investigates.

For many investors, the choice between using an individual savings account (Isa) or a self-invested personal pension (Sipp) to save for retirement has always been a tough one.

Sipps offer more generous tax breaks overall, but Isas are more flexible. This year's Budget has made the decision even more finely balanced.

Chancellor George Osborne is making it easier to access your pension funds in retirement, but has also made small improvements to the Isa rules. So which is the best option?

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Sipps beat Isas on tax

There are minor differences: for example, dividends from US stocks are tax-free in a Sipp (if your administrator supports this), but have 15% tax deducted by the US government if held in an Isa. However, the impact of these quirks is small for most investors.

The main difference in tax treatment lies in how you are taxed on contributions and withdrawals. With an Isa, you receive no tax relief on contributions, but you are not taxed on withdrawals.

Pension contributions, on the other hand, receive tax relief at your marginal income tax rate (so 20% for a basic-rate payer, 40% for the next level up), but you will be taxed on the income you draw. However, you can also take out 25% of your pension fund as a tax-free lump sum which is where pensions score highly over Isas.

The table below estimates the net gain from using a pension rather than an Isa, depending on your starting and finishing tax band (we've left out the 45% rate, but the potential gains here are even greater).

There is a substantial gain if you pay tax at a higher rate while contributing, then at a lower rate on retiring. But even those who pay tax at the same rate either side of retirement will do better in a pension.

How much can you save?

With a Sipp, you can contribute up to £40,000 in the current tax year and get tax relief at your marginal rate. But you can'tcontribute more in any tax year than you've earned so if you earn £20,000, you can only contribute £20,000 (including the tax relief).

This applies across all your pensions, so if you pay £10,000 into a workplace pension, for example, you can only pay up to £30,000 into your Sipp. However, everybody can get 20% tax relief on contributions of up to £3,600 gross of tax, even if you have no earnings (so you can set up a pension for a child or grandchild, for example).

Once your money is inside the wrapper, there is no cap on how large your Isa portfolio is allowed to grow (although there has been talk of changing this). But pension funds are subject to a lifetime allowance', currently £1.25m (across all your pensions).

If the total value of your pension funds at retirement is greater than this, the excess is taxed at 55%. This cap has been steadily reduced over time, so it's impossible to predict whether or not it might affect more investors in the future.

Instant access

The new rules on pensions taking effect in April 2015 should make it possible to withdraw all of your money as soon as you reach retirement, if you want to, but full details haven't yet been announced and anyone withdrawing all their money (certainly from a large pot) could expect to pay a significant amount of tax.

In terms of investments, Sipps have the edge on flexibility. Almost all types of investment can be held in them, while the list of Isa-eligible investments is smaller. For example, if you want to invest directly in commercial property, you can do so through a Sipp.

However, most mainstream Sipp accounts offer only a restricted range of investments and most investors will never need more so this isn't a key difference for most people.

Start with an Isa

However, your savings will still be inaccessible until you are 55 at the earliest and there is every chance the rules could change again before you come to retire this political risk is probably the biggest drawback to Sipps. Sipps are also usually a bit more expensive than Isas, which will steadily eat into the tax gain.

So we still think it usually makes sense to focus on using up your Isa allowance before contributing to a Sipp, especially for younger investors. You lose a tax break, but gain flexibility and take less of a gamble on the tax system changing in the next 20-30 years.

For higher-rate taxpayers who are nearer retirement and already have significant Isa savings, the balance may tip in favourof Sipps.

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Row 0 - Cell 0 Row 0 - Cell 1 Marginal income tax rate in retirement
Row 1 - Cell 0 Row 1 - Cell 1 0%20%40%
Marginal income tax rate while contributing0%25%6.25%-12.5%
20%25%6.25%-12.5%
40%66.67%41.67%16.67%
Cris Sholto Heaton

Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.

Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.

He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.