ISAs vs. sipps - pros and cons

INTRO
In the UK, we are extremely fortunate to have some of the best tax efficient accounts in the world. Yet in 2021, only 3% of the population make use of ISAs. So I think it's super important that I make a post about these various tax efficient accounts or "wrappers" to get more people on board and to wake up to the beauty of these accounts available to us. I will also weigh up the pros and cons of ISAs vs SIPPs, and in which circumstances they work best.

ISA BASICS
There are 5 types of individual savings accounts (ISAs) which are available to UK residents. You can have all 5 ISAs if you wish and you can put money into each of them every tax year. However, there is a £20,000 yearly allowance across all of the ISAs, except for Junior ISAs which have a separate yearly allowance. So if you were to put £5,000 into one ISA, you would have a £15,000 allowance left to put into the other ISAs for the remainder of the tax year.

Money within an ISA can grow i.e. earn interest or dividends completely tax-free, which is what makes these accounts unique and unstoppable. No matter how large your capital gains become, it will still be tax free as it is wrapped safely within an ISA. The tax year runs from April 5th – April 4th the following year, so it's always beneficial to try use as much of your yearly ISA allowance as possible before the new tax year. Unfortunately, if you don’t use your ISA allowance for a tax year, it does not roll over. 

LIVE ABROAD?
It's important to note that if you move country after opening an ISA it will stay open but you cannot continue contributing. If you are already living in another country and do not have an ISA already open, unfortunately you are ineligible to open an ISA even if you’re a British citizen.

1. CASH ISA
Cash ISAs are savings accounts available to UK residents 16+ where you can earn interest as you would in a regular savings account, except for in a Cash ISA it is tax-free - it's that whole wrapper effect! There are two types of cash ISAs:

1. Easy Access Cash ISAs - In this type of ISA you are able to access your money when you want without penalty. However, these tend to have lower interest rates which currently sit around 0.4%
2. Fixed-rate Cash ISAs - In this type of ISA, you will need to keep your money within the account for a set term e.g. 1 year, 2 years, 5 years. If you withdraw outside of this term you will be penalised, but how much of a penalty will depend on the account you have with your provider. Interest rates for this type of Cash ISA currently range from 0.5% - 1%.

​2. LIFETIME ISA (LISA)
Available for UK residents to open between the ages of 18 and 40, this account technically has the most restrictions but also provides the best bonuses. The money within this type of ISA can be used for 2 things: 1) first-time home purchase and,  2) Retirement (60+). You can either choose to keep your money within the LISA in cash and/or you can invest it into stocks and shares. 

You can put a maximum of £4,000 per year in this account, and this would be a portion of your total £20,000 yearly ISA allowance. Now for the great part - for every £4 you put into this account, the government will add an additional £1 (25% bonus) until the government have given you a maximum of £1000. So, if you wanted to benefit from the full government bonus, you would need to deposit £4000 into your LISA per tax year. If you decide to withdraw the money outside of these restrictions, however, you are penalised by 25%, so essentially you'll lose the government bonus. And of course, as it is an ISA, the interest earned within this account and the government bonuses are tax-free.

Now for the restrictions of this type of ISA:

1. You can only contribute to LISAs until your 50th birthday
2. If you use the money towards a 1st time home purchase, you only are allowed to buy a home up to £450,000
3. The account must be open for 12 months in order to use these funds for a home purchase
4. You will need a conveyancer or solicitor to process this withdrawal for your home purchase

​3. STOCKS & SHARES ISA (S&S ISA)
This account is available to UK residents 18+. Money within this account can be invested in various assets such as stocks and shares, bonds, commodities or even property. There are no restrictions or penalties for accessing the money within this type of ISA at any point. Just like all of the other ISAs, you do not pay tax on any interest or dividends earned within the ISA.

Of course, when it comes to investing your capital is at risk, so you have to always exercise caution and understand the risk involved when investing. Generally speaking, it is best to take a long-term approach when investing in a S&S ISA, at least 5 years, but preferably 10 years or more.

4. JUNIOR ISA (JISA)
A parent, guardian or carer can open a Junior ISA for a child in the UK resident under the age of 18. There are two types of Junior ISAs: 1) Children’s version of the S&S ISA and, 2) Children’s version of the Cash ISA. You can have both types of JISAs and also pay into both, as long as you stay within  the JISA annual allowance of £9000. Again any capital gains earned are tax-free.

The child will not have access to this account until they are 18, at which point the JISA will convert into an adult ISA (either a Cash or S&S ISA) and therefore they will be able to do what they want with the money at that point.
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If you were someone who opened a child trust fund before junior ISAs came into effect in 2011, the child will not qualify for a Junior ISA.

5. INNOVATIVE FINANCE ISA
This is an ISA available to UK residents 18+. It allows you to partake in a peer-to-peer lending scheme, where you loan money to a pre-approved business or individual and the borrower would be expected to pay you back the loan money plus interest over a set term. Again, as this is done within an ISA, the interest earned would be tax-free.

However, as a bank is not involved in the process, it carries higher risk that borrowers can default on their loan and essentially not pay you back for the loan. Furthermore, innovative finance ISAs are not covered by the financial services compensation scheme, therefore if someone was to default on the loan you would not be able to claim your money back through the scheme. 


SELF-INVESTED PERSONAL PENSIONS (SIPPs)
SIPPs are personal pensions that allow you to make your own decisions about your investments in preparation for retirement. It is available to UK residents 18+ and has an annual allowance of £40,000 OR your annual salary if it is below £40,000. In other words, if your salary is £30,000/year, your yearly SIPP allowance would be £30,000. Currently, money within SIPPs cannot be accessed until 55 years old, and from 2028 it will increase to 57 years old.

Amazingly, SIPPs are even more tax efficient than ISAs as they provide the same tax benefits as traditional pensions. If you are a basic rate tax-payer and pay 20% income tax OR do not pay any income tax as you earn under the threshold, the government will add 20% into your SIPP, which means that the money you contribute to a SIPP are tax-free. If you are a high-rate tax payer and pay 40% or 45% income tax, the government will add 40% or 45% into your SIPP. Moreover, any capital gains within a SIPP account are tax-free. So essentially, there is a double-tax saving on money held within a SIPP.

ISAS VS. SIPPS
To help put all of the information into perspective, let's go through the top pros and cons of both ISAs and SIPPs, and why one may work better than the other in certain circumstances, However, I do want to point out that you can absolutely get the best of both worlds and have both a SIPP and an ISA(s).

• ISA Pros & Cons
  • There are a variety of ISAs to meet different needs 
  • You do not pay any tax on any capital gains earned
  • The money within most ISAs can be accessed at any point with no age restrictions
  • You do not receive tax relief on money you put into an ISA
  • The annual allowance is smaller than a SIPP (currently £20,000)
• SIPP Pros & Cons
  • You have more control over your pension investments than traditional pensions and are able to hold your pension with a provider who offers lower fees
  • The contributions made into a SIPP receive complete tax-relief
  • The annual allowance is large (currently £40,000)
  • You are not able to access the money until retirement (55/57 or older)
  • You do pay tax when you withdraw your money from a SIPP (except for the first 25%)
  • There is a Lifetime Allowance (currently £1,073,100) where you pay an additional tax if your SIPP and/or employer-based pension ever surpasses this amount

​Who should consider an ISA and/or SIPP?

1. S&S ISA Good For Investors - Anyone who is interested in investing should definitely consider a S&S ISA. Unlike a general investment account (GIA) where you will have to pay capital gains or dividends tax when earning above a certain threshold, capital gains and dividends earned within an ISA are tax-free.
2. Lifetime ISAs Good For Home Buyers - If you are looking to get on the property ladder as a first-time home buyer in a year or more, you can get up to a £1000 per tax year if you max out your LISA allowance of £4000 per tax year. It's a great bonus!
3. JISAs Great For Parents - Junior ISAs are a great way to set your children up well for their future and to have an account for them that can hopefully grow in line (or more) than inflation if you choose to invest it.
4. SIPPs Great For Knowledgeable Investors - If you are someone who knows about investing and have specific desires (e.g. ethical investing), SIPPs are great to take more control over your pension investments
5. SIPPs Important For Self-employed or Business Owners - Pensions are undoubtedly important but not something everyone has especially if they work for themselves. SIPPs are important for those who do not have an occupational/employer-based pension but knows the importance of setting themselves up for retirement 
6. SIPPs Good For High-Earners - As the tax relief is large (40% or more) it's a great way for high-earners to pay less in tax and keep more in their pockets
7. SIPPs Good For Beneficiaries - As SIPPs are not subject to inheritance tax (if the SIPP owner dies under the age of 75), it is a very tax efficient way of passing on wealth to beneficiaries without having to worry about large inheritance tax on the SIPP holdings

Please find below some very credible links which also cover ISAs and SIPPs:

https://www.wealthify.com/blog/isas-explained https://www.moneysavingexpert.com/savings/isa-guide-savings-without-tax/ https://www.hl.co.uk/pensions/sipp/what-is-a-sipp https://www.moneysavingexpert.com/savings/cheap-sipps/

And of course - please write me a comment if you found this useful :)