One of the most common questions from investors and saves alike is, “What’s better, an ISA or SIPP?”

This question encapsulates a few common misconceptions, questions and conundrums from our readers:

  • “If I start a SIPP (a self-invested personal pension) I know I can get tax relief, but am not sure how it works?”
  • “Pensions are great when paying in, but then you have to pay out tax when you’re a pension - will I be better off?”
  • “ISAs are better because you don’t get taxed when you start drawing money out”
  • “ISAs are better because you can withdraw the money anytime if you need to”
  • “Should I invest in an ISA or Sipp or both?”
  • “I don’t know how to pick stocks or funds, so is a pension easier to buy into?”

We’ll answer these questions, through a case study:

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Two 48 year olds earn £30,000 and save £250 a month until they are 55

  1. One invests in a ISA, the other in a SIPP
  2. They both build a well diversified portfolio of global funds that deliver an average return of 12% p.a.* rather than buy into an ‘off the shelf’ pension.
  3. Nether saver needs the option to withdraw any money during these twenty years, as both had very good job security, and this money it is purely for their retirement

*In the real world the investment return will fluctuate, but in this example we have taken is as identical each year to make comparison of the two wrappers easy.

**To make this example easy to understand we have not taken inflation into account - it will affect both savers in the same way. When doing a cashflow forecast for your retirement, an IFA would take into account both inflation and variations in investment return.

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  1. The ISA saver invests £250, and the government make no contribution
  2. The SIPP saver invests £250, then receives an extra £62.60 (20%), making the total monthly investment £312.50
  3. There are no other differences between the two
  4. With 20 years compound interest their investment pots look like this:
    1. SIPP £309,142
    2. ISA £247,313

So the tax benefit makes an enormous difference when compounded monthly, over 20 years.

Both 68 year olds retire and live for 20 years, and only have two incomes; their state pension and this investment.

The SIPP holder, because they have not bought an off-the-shelf pension product, asks their financial adviser to put their funds into easy-access drawdown, so it is as easy to draw money as it is for the ISA holder.

Both spend £1,000 per month on top of their full state pension (based on £185.15 per week).

The SIPP holder now needs to withdraw more, because they have to pay income tax.

The SIPP holder will withdraw £276,195 over their retirement.

The ISA holder will withdraw £240,000 over the same period.

The SIPP holder gained tax relief of £12,000 when employed, and then paid £36,000 in tax when retired. But has gained £62,000 overall in compound investment gains on all the money invested, so is better off than the ISA holder.

The SIPP holder has a bigger margin for surprise problems that require capital spend (for example a boiler or car breakdown), and can live longer without running out of money.

The ISA holder may need to reduce their spending later in life, depending on how they invest during the retirement period.

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If both savers had significant additional work pensions, that pushed their retirement into the higher tax band, these figures change.

If the savers started saving much younger, but then found themselves out of work for a period or in need of money for an emergency, the ISA holder can access their money and has greater flexibility.

Summary

An ISA is more flexible, a SIPP slightly more profitable.

If you might need to access the funds you are saving before 55 years old, an ISA should probably be your main investment wrapper,

But a SIPP will be more profitable if you are only saving and investing funds that you definitely won’t need until you are over 55 year of age.

In both cases, getting a professional cashflow forecast and investment portfolio designed to suit your personal circumstances will make making the right decision easier.

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