In the near future we may well have some free cash to re-invest. Been mulling over the two possibilities of putting into an ISA or into a SIPP, specifically, my wife’s SIPP as hers is not that large and there is no imperative to start taking any for many years.
Intuitively, given it will be more than a decade until she may need to touch the money the first thought is a SIPP as the tax uplift when putting the money in (an additional 20% in her case) can only lead to a higher fund due to the compounding effect.
But actually, I decided to have a look at the figures and see. It is a bit tricky really as it all very much depends on your personal tax position as I found out. To demonstrate this I need to simplify the working to clearly show the effect I found. In others personal case a few other factors may come into force.
So it’s say I want to invest a single fixed sum of £4K. (Computationally, multiple sums just blurs it all, and the same effect can be shown with a single payment)
For a SIPP she gets tax relief (and this is where it gets a bit complicated). For a basic rate taxpayer 20% is added and if a higher rate 40% (subject to some restrictions). Just ignore the other cases as they are a bit special (like being a non-tax payer or earning in the very high bands)
Again for simplicity, I will just assume I get a fixed 3.5% return (after costs) and my time horizon is 10 years then:
For a basic rate taxpayer:
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- £4K gets 20% uplift calculated at Sum/1.25, so £1K. The investment into the SIPP is therefore £5K. Easiest way to calculate the compounding is Invested amount * (1 + int rate)^ years. So (1+ 3.5%) ^ 10 = 1.4106. So my £5K invested multiplied by this becomes £7,053 in 10 years
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- For a High rate taxpayer, my £4K becomes £6,67K invested and ends up as £9,404 in 10 years
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- For the ISA, I get no tax relief so my £4K becomes £5,642 after 10 years.
ie,
But what happens after my 10 years. That depends on the tax rate you pay. It would be unreasonable to not expect to pay tax. The wife’s small defined benefit pension added to her then eligible state pension will go over the tax threshold, so at least a basic rate taxpayer is expected, and this will almost certainly be the case for most people. At basic rate (and ignoring any high rate thresholds for simplicity as in her case they won’t apply anyway), anything taken out of the SIPP is taxed at 20% (current rate). So:
- Basic rate taxpayer => £7,053, tax of £1,411 (20%) giving a net of £5,642
- Higher rate taxpayer => £9,404, tax of £3,762 (40%) giving a net of £5,642
- ISA => £5,642 net
WOW …
They all the same… this is not at all what I expected. Yes I have simplified a bit, but fundamentally, run the numbers, and astonishingly they come out the same.
I must be missing something surely. That would be far too joined up of government after all !!…
Well, there is the current vagary of the tax system and the endless tinkering governments do with limits, thresholds and allowances. Currently there is a lifetime allowance where up to 25% can be taken tax free. (Thankfully the mad marxists did not get the keys to the cookie jar, so I would not expect that to change inside the next 5 years or more), so it is a reasonable assumption that she can claim 25% tax free. Now that affects the tax paid, so must affect the net received.
How could I really evaluate this ? Well we can invest at a Nil rate, Low rate or High rate tax and then withdraw at Nil, Low or High rate.
Essentially though there are only 5 cases as it is a fair assumption that tax will be payable on taxable income as in most cases the total income will be over the tax allowance thresholds.
So, our five cases are:
1. Invest as a High rate Taxpayer, withdraw as a High rate taxpayer
2. Invest as a High rate Taxpayer, withdraw as a Low rate taxpayer
3. Invest as a Low rate Taxpayer, withdraw as a Low rate taxpayer
4. Invest as a Low rate taxpayer, withdraw as a High rate taxpayer
5. Invest in an ISA – no tax uplift, no tax on withdrawal
2. Invest as a High rate Taxpayer, withdraw as a Low rate taxpayer
3. Invest as a Low rate Taxpayer, withdraw as a Low rate taxpayer
4. Invest as a Low rate taxpayer, withdraw as a High rate taxpayer
5. Invest in an ISA – no tax uplift, no tax on withdrawal
Cases 1, 2 & 4 are not relevant to my wife, but for completeness may well be to others.
1. £4K + 40% x 1.4106 = £9,404. Tax free = £2,351, tax (40%) = £2,821; net => £6,583 [+16.7%]
2. £4K + 40% x 1.4106 = £9,404. Tax free = £2,351, tax (20%) = £1,411; net => £7,993 [+42%]
3. £4k + 20% x 1.4106 = £7,053. Tax free = £1,763, tax (20%) = £1,058; net =>£ 6,005 [+6.4%]
4. £4K + 20% * 1.4106 = £7,053. Tax free = £1,763, tax (40%) = £2,116; net => £4,937 [-12.5%]
5. £4k * 1.4106 = £5,642 (no tax to pay).
2. £4K + 40% x 1.4106 = £9,404. Tax free = £2,351, tax (20%) = £1,411; net => £7,993 [+42%]
3. £4k + 20% x 1.4106 = £7,053. Tax free = £1,763, tax (20%) = £1,058; net =>£ 6,005 [+6.4%]
4. £4K + 20% * 1.4106 = £7,053. Tax free = £1,763, tax (40%) = £2,116; net => £4,937 [-12.5%]
5. £4k * 1.4106 = £5,642 (no tax to pay).
So if you find yourself in case (4), ie, a Low rate taxpayer, but there is a good chance of moving to a high rate taxpayer in retirement, then pretty well obvious put the money into an ISA. This is not a scenario that will be that uncommon. In all other cases there is a material benefit to putting money into a SIPP, although one (at +6.4%) is marginal.
Note that should I play a game and remove the tax free element (as some government may do this) then relatively we get:
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- case 1 – 5,642 => 0% difference
- case 2 – 7,523 => +33.3%
- case 3 – 5,642 => 0% difference
- case 4 – 4,231 => -25% worse off.
In other words, only when investing as a high rate tax payer and expecting to be a low rate one in retirement can you always guarantee a benefit. Note that it is far worse if you are currently a low rate taxpayer and expect to become a high rate one. (Arguably if this is the case you need to minimise taxable income so would not want to put more into a pension fund, but there are inheritance benefits that can complicate this balance).
This is interesting as it points to the only case where a SIPP may be better off, that of contributing as a high rate taxpayer and withdrawing at a lower rate. Yes, with tax free amounts only the case of contributing at a lower rate and withdrawing at a higher rate makes you materially worse off, but the difference is relatively small in two cases (6% and 16%). So in the end you take a view on relative risk and the changes to the tax system.
I could hazard a rule of thumb for this really:
Invest in a SIPP if you are a high rate taxpayer, otherwise an ISA is a better choice
It has been interesting to look at this and very much clarifies my own view of how we proceed. There are no normal circumstances that additional contributions to my wife’s SIPP should be made. In other peoples cases, it depends on whether you are a high rate taxpayer or not.
But have I not created a ultra-simple scenario. Well yes and no. It is intuitively obvious that investing for several years has the same relative outcomes (just a 9, 8, 7 etc year compound factor applied to each successive contribution), so a single lump is enough to see the bigger picture mathematically.
But just to show it, if I apply this model annually for 10 years and then withdraw at a rate that sees the fund depleted over the years to age 85, then we get the following:
Easy to construct and adjust parameters (like investment tax relief, taking a tax free sum etc). Going through the options I can summarise the outcomes as:
This is entirely consistent with just looking at the outcome of a single lump payment in – it is all just relative scale.
So in summary, for our particular case, there is no reason to invest upcoming spare cash into my wife’s SIPP and instead we gain greater long term benefit by putting it into an ISA. The ‘seduction’ of input tax relief is just that – a seduction.
For others, the situation may be different and is wholly dependent on your individual and expected tax position. Doing a bit of modelling means you can ignore ‘experts’ who give blanket statements, and instead look at maximising your own value.
Note:
None of the above constitutes investment or tax advice. I have simply written about my analysis of our personal situation and offered a conclusion. Always do your own research and analysis.
This is a really interesting post.
Interesting read. As a basic tax rate payer, I too saw no difference between saving in a SIPP and ISA (although I have both).
Monevator did a different take on this: https://monevator.com/how-pensions-will-help-you-reach-financial-independence-quicker-than-isas-alone/ and I’m now of the view that SIPPs, with the tax relief and the 25% tax free lump sum have the edge over ISAs, though not the flexibility. I’ll just continue to pay into both.
Yes … a slightly different take. It is really about a balance I expect, but it did surprise me how very beneficial the alliance system is to higher rate tax payers.
I have a good balance of both but no longer putting anything into SIPP’s
Hi, good read! Am i mistaken or are you suggesting it’s quite common to be a lower tax payer in work life but higher in retirement ?! Are you suggesting the former only the case due to high sipp contribution to bring in line with basic tax bracket pre FI? Seems more common to FI at a basic rate even if ur not yourself? Since i currently live on half my salary, don’t imagine it’d change that much. Or do u have experience plans? Just curious. Thanks!
No … but that scenario does exist with good investment returns in a SIPP. The boundary of Low Rate-High Rate in the UK is narrowing and more people will be and are caught when they don’t expect to be.
So you’ve written off a 6.4% gain for a same rate tax payer as ‘marginal’ to justify your proposal that ISA is better for you, thats a pretty misleading tactic.
Also if you have no other sources of income you could control your withdrawals from the SIPP using Flexi Access Drawdown to avoid paying income tax. I.e. at the current Personal Tax Allowance (12500) you could remove £16667 from a SIPP without paying income tax (assuming no thoer sources of income). Therefore pushing your wife into a new case of being a basic rate payer on deposit and nil rate on withdrawal.
Thanks for taking the trouble to comment with some detail.
I take your point … 6.5% on its own looks a solid material benefit I agree, but my assessment was over 10 years so that equates to an annualised rate of 0.6%. That is small and in my mind essentially noise. The 34% gain is essentially an annualised rate of 3% (much more substantial).
As for the second point, you are correct only if there are no other income sources, but that is not the case and the allowance is used up. What surprised me the most was that a high rate taxpayer get a materially significant benefit over a standard rate taxpayer. The vagaries of the system I suppose
I still think your ignoring the gain just to justify your point, at the end of the day its still a gain over the ISA whether you look it as a annualised rate or not. Given the same withdrawal rate you still gain 6.4% more over the ISA because of the 25% tax free amount.
The real argument isn’t ISA vs SIPP but whats the most beneficial amounts to have in each to maximise gains and minimise tax, it isn’t a simple one or the other.