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Core benefits

Greater choice has become the expectation in everything we buy but too much choice can confuse us to the extent that it destroys our ability to make decisions. Tax wrappers are no different. When it comes to self-invested personal pensions and Isas, the investor has never had it so good.

The changes to Isa regulation coming into force from April make them an even more attractive proposition while the A-Day changes nearly two years ago made Sipps more flexible and accessible to the mass market. Yet how do you choose which wrapper – a Sipp or an Isa – is right for your client? Should they be taking advantage of both?

To come to any fair conclusion, you have to examine the technicalities of both wrappers. The basic facts are that your client will get taxed on the way in with an Isa and on the way out with a Sipp.

A difference that may have more resonance depending on your client’s financial situation is that they can take money out of their Isa whenever they want. With a Sipp, the money is locked in until retirement. This is the price you pay for tax relief of up to 40 per cent.

A comparison between Isas and Sipps in the accumulation phase shows that Sipps have a significant advantage when investing long term for retirement, as tax relief means the gross contribution for a Sipp is bigger than the contribution for an Isa. The pension pot can therefore grow more strongly than an Isa. This is the case even for basic-rate taxpayers. For higher-rate taxpayers, the results are more pronounced but the initial outlay is bigger until higher-rate relief is reclaimed.

How do Sipps and Isas compare in the income phase? To reiterate an earlier point, your client will get taxed on the way in to an Isa but not on the way out and vice versa for Sipps. Does that even things out?

Investments held in the Sipp have to work harder in retirement to achieve the same income as an Isa but the Sipp has had more contributions and more compound growth over its lifetime, so it can sustain its advantage ahead of the Isa.

In fact, as long as the income is based on the same net amount, the Isa fund will not outperform the Sipp, whether for a basic or a higher-rate taxpayer.

Based on these simple calculations, Sipps seem to win out over Isas both in the accumulation and income phases. However, before you banish Isas in favour of Sipps for retirement saving, there are other factors to consider.

The one we are all most familiar with is that your client will have to wait until they are between age 50 and 55 (from 2010) to access any investments in a Sipp. Isas are much more flexible and investments can be taken out at any time.

Income is another consideration. Pension income in retirement is taxed at your client’s highest rate of income while they will not be taxed for taking income from their Isa.

Sipps offer a much higher annual investment allowance while the Isa limit currently sits at £7,000.

You should bear in mind that the choice of wrapper has an impact on the funds inside it. For example, switching funds within a Sipp is usually free while it tends to incur a charge in an Isa. The funds in a Sipp are treated differently for legislative and tax purposes.

This is not an exhaustive list of the differences and each wrapper comes with a caveat that tax rules may change in future.

Other factors which you may want to consider when selecting the right wrapper for your client include:

  • Twenty-five per cent of a Sipp fund can be taken as tax-free cash.

  • A client who is a higher-rate taxpayer during the accumulation phase may no longer pay higher-rate tax by the time they come to take income from the plan.

  • At lower levels of income, there is the interaction with state benefits to consider.

    The Sipp may outperform the Isa on a like-for-like basis but the Isa has many advantages of its own, such as the ability to encash the full capital value at any time. The two wrappers can work well together but what is best for a client’s retirement savings will ultimately determine the answer.

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