The pros and cons of ISAs versus SIPPs

If theres one thing governments are good at, its taking a simple thing and making it needlessly complicated. Take the Individual Savings Account (ISA). Weve had the Stocks and Shares ISA, the Cash ISA, the Mini ISA, the Junior ISA, the Lifetime ISA

Im investing to build a retirement pot, and the only one of those I reckon I need is a regular Stocks and Shares ISA.

I have a Self Invested Personal Pension (SIPP) too, also invested in UK shares. Why both? They offer tax advantages, but in different ways.

Tax-free profits

An ISA offers no tax relief on the money you invest. Instead, you dont have to pay any tax on your gains when you eventually take money out. Dividends are generally paid with basic rate tax already deducted, but you wont be eligible for any more tax when you cash in your ISA, no matter how much youve accumulated or what your tax band is.

Capital gains are tax-free too, no matter how much profit youve made. There are an estimated couple of hundred ISA millionaires in the UK these days, and HMRC is not going to get its hands on a single penny of their cash.

There are limits to the amount you can invest in an ISA, but the current allowance of 20,000 per year is substantial.

Tax relief on contributions

A SIPP works differently, and gives you tax relief on money when you put it in. As an example, for every 100 of gross salary you earn at the basic tax rate of 20%, youd usually pay 20 in tax and be left with 80. But if you put that cash in your SIPP (or a company pension), the government will waive the tax on it and youll get to invest the full 100.

But there is a catch. When you eventually draw down your pension, its taxable. So whats the point?

There are several benefits. Firstly, when you qualify for drawdown (currently at age 55, barring special circumstances like serious illness), you can take a lump sum of up to 25% of the total pot tax-free.

Then of the remainder, whatever you draw down each year falls under standard income tax rules. So, based on current tax bands, you can take 11,850 of pension income per year at zero percent tax.

Lower tax bands

Anything above that and up to 46,350 is taxable at the 20% basic tax rate, so you might think thats the end of the benefits.

But if you were in the 40% higher rate bracket when you put your cash into your pension, youd have enjoyed 40% tax relief at the time. And youll still only have to pay 20% tax on draw-down, provided you dont take more than46,350 per year.

Limits

There are tax-free contribution limits to pensions too, which includes SIPPS. There are some complicating factors it is a government thing, after all. But generally, youre able to contribute up to 40,000 per year with tax relief, providing the total doesnt exceed your actual income.

Theres a lifetime limit too, currently of 1.03m, though Ive not come close to that being a problem myself.

Now you know the tax benefits of ISAs and SIPPs, you can get your next tax years savings off to a great start.