Which are better: ISAs or SIPPs?

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Which is better, an ISA or a SIPP? The truth is that self-invested personal pensions are more tax efficient than individual savings accounts, but ISAs are more flexible. However, a good retirement strategy will include both types of savings account.

What are the tax differences?

The SIPP is more tax efficient because you receive tax relief on your contributions, so the gross amount grows and compounds up. The government grosses up pension contributions according to your tax band. This is done automatically for basic-rate taxpayers, but higher-rate taxpayers need to claim back their extra relief separately.

Note too, non-taxpayers also receive 20% basic-rate relief (up to £3,600 gross). Grossed up, basic rate and non-taxpayers making a net contribution of £1,000 receive £1,250, higher-rate taxpayers get £1,667, and those on 50% get £2,000.

However, tax is payable when an income is taken from your SIPP. In comparison, an ISA gives you no tax relief on the way in, but the proceeds are free of tax.

A SIPP is more tax-efficient than an ISA for two additional reasons:

• You can take 25% of your SIPP as a tax-free lump sum

• You are likely to pay less tax in retirement than while you are working. This is particularly true for higher-rate taxpayers who receive 40% tax relief on their contributions but will probably only pay 20% tax on their pension income in retirement.

You currently need an income of £41,865 to be a higher-rate taxpayer. "To generate a retirement income of that level you would need pension savings of approximately £1.1 million," calculates Laith Khalaf, pensions analyst at Hargreaves Lansdown.

"Relatively few pensioners are therefore 40% taxpayers in retirement, with the possible exception of super-taxpayers who receive 50% tax relief on their contributions now. Even basic-rate taxpayers will pay less than 20% tax on a large chunk of their income in retirement because the first £10,500 of your income is tax-free if you are over 65."

But aren't ISAs more flexible?

Yes. ISAs are more flexible because you can draw income at any time. You can only draw from a SIPP from age 55, and only 25% can be taken as a tax-free lump sum.

However, under new pension rules from April 2015 you will have free access to your pension fund after the age of 55.

What about inheritance tax?

In this respect the SIPP is the winner, because its proceeds fall outside of your estate, whereas ISA proceeds do not and are therefore potentially liable to inheritance tax.

Are there any other potential considerations?

Pension income could be eroded if income tax rates rise in future.

Another advantage of ISAs is their income doesn't need to be entered on a tax return, so it doesn't count towards the limit for the increased age-related personal income tax allowance available to those aged 65 and over.

"For most of us it makes sense to use both pensions and ISAs when saving for the future," says Justin Modray, founder of Candid Money. He adds that the extent to which you use one over the other will depend on how you think your tax status will change over time and how much flexibility you need.

This article was taken from the April 2011 issue of Money Observer and edited on 20 October 2014.