ISAs vs. sipps - pros and cons
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.
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.
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:
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:
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.
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).
Who should consider an ISA and/or SIPP?
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 :)
30-year old living in the UK who is actively working towards achieving Financial Independence (FI). Sharing all the tips and tricks I am learning along the way!