7th November 2014
James Yardley, Research Analyst
The changes announced in the March budget were good news for investors, and the Savers' Revolution looks set to continue. George Osborne's latest move was to scrap the 55% death duty currently levied on pensions. So, where has this left investors? Should we be putting our money in an Individual Savings Account (ISA)or a Self-invested personal pension (SIPP)? The wrong choice might cost you thousands of pounds, so it's worth researching.
How do the products currently stand?
The new ISA, or NISA, is very similar to its predecessor but is much more flexible. It still provides shelter from both capital gains tax and interest paid out, but you can now invest up to £15,000 annually instead of £11,880; a welcome increase. The other major difference is that the product is now more flexible - you can now switch back and forth between a stocks and shares ISA and a cash ISA.
In the March budget, Chancellor Osborne announced major reforms for defined contribution pensions:
Pensioners will have complete freedom to draw down as much or as little of their pension pot as they want, anytime they want. No caps. No drawdown limits. Let me be clear: no one will have to buy an annuity. From April 2015, investors will no longer be forced into buying an annuity which, at today’s low interest rates, typically offered a poor level of income. Just this week, Osborne has gone further, and made pensions even more attractive by scrapping the 55% death duty tax currently levied on your pension pot after you die. This leaves even less reason to buy an annuity.
Let’s examine the new SIPP first of all.
SIPP - Advantages:
- You get your tax back just for investing. The basic rate of tax is automatically added to any personal contributions. For example, if you contribute £80 the government adds another £20 to make a total of £100 (£80/0.8). Higher rate and additional rate tax payers can also claim back even more tax from HMRC on their tax return.
- You get protection from capital gains tax.
- You can take 25% of your SIPP as a tax-free lump sum at retirement.
- Currently anyone who inherits a SIPP from someone over the age of 75, or from someone who is currently drawing an income, has to pay 55% tax. The exceptions being spouses and children under 23. * The new law will mean anyone who inherits a SIPP from someone who is under the age of 75 is liable to no tax. If the SIPP is inherited from someone over the age of 75 the SIPP can now be drawn down at the inheritor's marginal rate of tax, either 0%, 20%, 40% or 45%.* You can now leave your SIPP to anyone, not just your spouse or a dependant, making them much more flexible.
- Like an ISA, there is no tax on interest earned on bonds or bond funds and a 10% tax cap on income from shares or equity funds.
- You can’t touch it until you retire. You must be a minimum of 55 years old (this rises to 57 in 2028).
- When you take money out from your pension pot you are charged at your marginal rate of tax (except for the 25% tax free lump sum).
- You are currently limited to contributing a maximum of £40,000 a year.
- Your total pension pot currently cannot exceed £1,250,000, the lifetime allowance, before punitive taxation of 55% on anything you draw down above this sum kicks in (the tax is only 25% for an annuity, but then you will have to pay your marginal tax as well). SIPPs are more complicated.
- There are charges for going into drawdown.
- Despite the recent changes, pensions are still inflexible compared with ISAs.
- Losses cannot be offset against capital gains.
ISA - Advantages:
- Any investments inside the ISA are free from capital gains tax.
- There is no tax on interest earned on bonds or bond funds and a 10% tax cap on income from shares or equity funds.
- There is no need to declare your ISA on your self assessment tax return.
- The money can be accessed any time - if you need it in an emergency or if you are saving towards a goal, for example buying a house.
- The ISA wrapper dissolves on death and your ISA investments just become part of your estate and are subject to inheritance tax.
- You can switch back and forth between a stocks and shares and a cash ISA depending on your investment needs.
- Simple, flexible and easy to understand.
- You are limited to currently investing a maximum of £15,000 a year.
- No tax relief on contributions.
- Losses cannot be offset against capital gains.
- ISA versus SIPP: where should you invest?
As is the case with all these questions, it depends on your own personal circumstances. You might think this question is most relevant to those nearing retirement, but it is also an important decision for younger investors.
Consider the following example:
A 25-year old invests £2,000 into both an ISA and a SIPP. The SIPP sum is increased by the basic rate of tax of 20% (£2000/0.8) to a total of £2,500. Both investments return 7% a year after charges.** At the age of 65 the SIPP is worth £37,436 and the ISA is worth £29,949.
At first glance the SIPP may appear better - you will always have a larger final lump sum by investing in a SIPP versus an ISA, because of the tax relief (assuming you make the same investment in both products). However, remember that you must pay tax, at your marginal rate, on any income you take out of a SIPP, whereas income from the ISA is not subject to further tax. The major benefit to the SIPP is that you can take a 25% tax free lump sum on retirement.
The new flexible drawdown option announced in the budget (due to come into effect next April) gives investors much more freedom and control over their SIPP when they come to take money out. The 25% tax-free lump sum means that, in most cases, you will be better off with the SIPP, even after accounting for paying the tax to take income out. One notable exception is when you move into a higher tax band when you retire. In this case, you might pay more income out when you retire versus what you received from the government when you paid into your SIPP in the first place.
One disadvantage of the SIPP, particularly when you're young, is that it locks your money away until retirement. Nevertheless, I hope the example above shows how important it is to start investing, no matter which vehicle you use. For those still in doubt, I would encourage you to read my previous article on compound interest.
Let us now consider ISAs versus SIPPs for older investors. Unlike younger investors, older investors at or nearing retirement, will be able to access their money sooner. In most cases, the combination of the tax relief when you invest and the 25% tax-free lump sum when you draw down, might make a SIPP a better choice versus an ISA. However, it will depend on your own personal circumstances, and investors must be careful how they draw down their money to avoid paying too much tax in one go. You should also be aware that SIPPs will typically come with extra charges when you enter drawdown. so this should be factored into any decision.
I will also add one important caveat: as we have recently seen, the government can change the rules at any time. We might have a new government next year and a new set of laws. Investors should prepare themselves for any scenario as best they can. With this in mind, we continue to like investing in both products, but you must ultimately decide what is best for you. If you're in any doubt, seek expert advice.
ISAs have been incredibly popular and remain a great tax-efficient and flexible product for savers. However, there is no doubt that Osborne's revolutionary changes have made investing in a SIPP look much more attractive than before. Long-term investors may want to consider investing more into their SIPP. Our parent company, Chelsea Financial Services, has recently launched the Cofunds SIPP, via the Chelsea FundStore, a low-cost, execution-only product designed to make investing in a pension as simple as possible. Any decision you make should be carefully considered.
* Source, http://www.bbc.co.uk/news/business-29408928 ** Chelsea Financial Services internal calculator