Actual tax benefit of SIPP vs ISA

spacemongoose

Hi,
I keep hearing that the main advantage of contributing to SIPP vs ISA is that the tax relief on SIPP contributions gives you a bigger pot which can grow much faster and be worth more. But it seems that in a common case the real effect is that of effectively paying 15% tax rather than 20% tax. I'm wondering if I'm missing something, because the 'bigger pot which can grow faster' argument seems to be spurious.

Suppose you are in the standard rate bracket when you contribute, but also (due to e.g. annuity income) you are unavoidably still in that bracket when you come to withdraw, the only benefit then seems to be the 25% that you can withdraw tax free, which amounts to a 5% effective reduction in tax rate over an ISA, and that's the only real difference.

E.g., for the sake of example, suppose in this situation, you put £8k into a SIPP.  Tax relief increases that to £10k.  You then invest, and when the time comes to withdraw it, it has increased by, say, 60%, to £16k.  You can withdraw £4k tax-free, and the other £12k at 20% tax, for a total of £13.6k. This is equivalent to paying 15% on the whole SIPP value of £16k.

Assume the same investment made as an ISA. You pay £8k into the ISA after having paid 20% tax up front. It gains 60%, to £12.8k.
You have no tax liability on this at all.

So, the SIPP is ahead, but only due to the 25% tax-free element, which reduces effective tax rate from 20% to 15%.

The fact that tax is up-front with the ISA, but deferred for the SIPP doesn't seem to make any difference, and nor does the fact that there's more actual money in the SIPP at the start. Only the 25% tax-free element gives a benefit.

E.g. your starting gross amount was £10k, before you paid 20% tax on it.
After the 60% growth, that would be £16k if you'd paid no tax at all.
With the SIPP, you finally got £13.6k, which is 85% of the gross (so 15% effective tax).
With the ISA, you finally got 1£2.8k, which is 80% of the gross (so 20% tax).

The fact that there's more actual money in the SIPP pot vs. the ISA one at all times doesn't really make any difference, since it's balanced by more tax to pay when you withdraw it.  The benefit comes from the 25% untaxed withdrawal, NOT the larger amount of money in the SIPP.

I can see that if when you eventually withdraw money from the SIPP you are in a lower tax band than the one you were in when contributing, then you gain substantially more, but this is still due entirely to the 25% allowance, plus the reduced tax rate - still nothing to do with the larger amount of money in the pot.

Am I missing something?

dunstonh

Suppose you are in the standard rate bracket when you contribute, but also (due to e.g. annuity income) you are unavoidably still in that bracket when you come to withdraw, the only benefit then seems to be the 25% that you can withdraw tax free, which amounts to a 5% effective reduction in tax rate over an ISA, and that's the only real difference.

Basic rate in, basic rate out equates to a 6.25% difference in favour of the pension.
Plus the pension is outside of your estate, unlike the ISA.

E.g., for the sake of example, suppose in this situation, you put £8k into a SIPP.  Tax relief increases that to £10k.  You then invest, and when the time comes to withdraw it, it has increased by, say, 60%, to £16k.  You can withdraw £4k tax-free, and the other £12k at 20% tax, for a total of £13.6k. This is equivalent to paying 15% on the whole SIPP value of £16k.

Assume the same investment made as an ISA. You pay £8k into the ISA after having paid 20% tax up front. It gains 60%, to £12.8k.
You have no tax liability on this at all.

In that scenario, the pension will be 6.25% higher in value on withdrawal.  As pensions and ISA can share the same investments and same charges, you can ignore the growth in your calculations to simplify it.

£10k pension contribution costs £8,000.    £10k drawn net of 15% effective rate tax = £8,500
£8k ISA contribution withdrawn is £8,000
The difference is 6.25% in favour of the pension.

I can see that if when you eventually withdraw money from the SIPP you are in a lower tax band than the one you were in when contributing, then you gain substantially more, but this is still due entirely to the 25% allowance, plus the reduced tax rate - still nothing to do with the larger amount of money in the pot.

The average retirement age in the UK is around 62-63.  So, if you retire earlier than state pension age there will be several years where your personal allowance could be available fully.  i.e. £16,760 from the pension would be fully tax free.  

Pat38493

spacemongoose said:

Hi,
I keep hearing that the main advantage of contributing to SIPP vs ISA is that the tax relief on SIPP contributions gives you a bigger pot which can grow much faster and be worth more. But it seems that in a common case the real effect is that of effectively paying 15% tax rather than 20% tax. I'm wondering if I'm missing something, because the 'bigger pot which can grow faster' argument seems to be spurious.

Suppose you are in the standard rate bracket when you contribute, but also (due to e.g. annuity income) you are unavoidably still in that bracket when you come to withdraw, the only benefit then seems to be the 25% that you can withdraw tax free, which amounts to a 5% effective reduction in tax rate over an ISA, and that's the only real difference.

E.g., for the sake of example, suppose in this situation, you put £8k into a SIPP.  Tax relief increases that to £10k.  You then invest, and when the time comes to withdraw it, it has increased by, say, 60%, to £16k.  You can withdraw £4k tax-free, and the other £12k at 20% tax, for a total of £13.6k. This is equivalent to paying 15% on the whole SIPP value of £16k.

Assume the same investment made as an ISA. You pay £8k into the ISA after having paid 20% tax up front. It gains 60%, to £12.8k.
You have no tax liability on this at all.

So, the SIPP is ahead, but only due to the 25% tax-free element, which reduces effective tax rate from 20% to 15%.

The fact that tax is up-front with the ISA, but deferred for the SIPP doesn't seem to make any difference, and nor does the fact that there's more actual money in the SIPP at the start. Only the 25% tax-free element gives a benefit.

E.g. your starting gross amount was £10k, before you paid 20% tax on it.
After the 60% growth, that would be £16k if you'd paid no tax at all.
With the SIPP, you finally got £13.6k, which is 85% of the gross (so 15% effective tax).
With the ISA, you finally got 1£2.8k, which is 80% of the gross (so 20% tax).

The fact that there's more actual money in the SIPP pot vs. the ISA one at all times doesn't really make any difference, since it's balanced by more tax to pay when you withdraw it.  The benefit comes from the 25% untaxed withdrawal, NOT the larger amount of money in the SIPP.

I can see that if when you eventually withdraw money from the SIPP you are in a lower tax band than the one you were in when contributing, then you gain substantially more, but this is still due entirely to the 25% allowance, plus the reduced tax rate - still nothing to do with the larger amount of money in the pot.

Am I missing something?

Also unless I'm missing something you made an additional £1200 beyond the 6.25% due to making a return on the additional 2K that was invested in the SIPP during that time.

In the first scenario after everything taken into account you will end up with £13600 after earning £10K gross.

In second scenario you will end up with £12800.

Interest on money that is taxed, is still better than zero which is what you had in the ISA.

leosayer

spacemongoose said:

The fact that there's more actual money in the SIPP pot vs. the ISA one at all times doesn't really make any difference, since it's balanced by more tax to pay when you withdraw it.  The benefit comes from the 25% untaxed withdrawal, NOT the larger amount of money in the SIPP.

I can see that if when you eventually withdraw money from the SIPP you are in a lower tax band than the one you were in when contributing, then you gain substantially more, but this is still due entirely to the 25% allowance, plus the reduced tax rate - still nothing to do with the larger amount of money in the pot.

Am I missing something?

You're correct in that, everything else being equal, it doesn't matter whether you are taxed at the beginning or the end - the end result is the same. 

However everything isn't equal particularly when there could be decades between contribution and withdrawal. Knowing what tax rate you will pay when withdrawing from the SIPP is uncertain. 

- Maybe no IHT and income tax will be payable by beneficiaries if you die before age 75 
- Maybe the basic rate tax will change to 10% and the personal allowance changes to £20k
- Maybe the funds grow so well you'll be a higher rate tax payer in retirement
- Maybe the government will introduce a wealth tax including pension savings
- etc.

There's also the human behaviour element - ISA funds are accessible but SIPPs aren't until later in life.

That's why the general advice is to use ISA and pensions.

r6mile

The benefits are also very high if you are a higher-rate taxpayer in employment, but likely to be a basic-rate taxpayer in retirement.

MallyGirl

If you also add in salary sacrifice into a pension which save NI (and sometimes even benefits from employer NI saving) then it swings further towards the SIPP side than the ISA side

Albermarle

As said if you are a basic rate taxpayer when contributing and withdrawing the tax advantage is 6.25% ( due to the 25% tax free) This can be increased in certain circumstances already highlighted, but if these do not apply, then it maybe be worth considering using a LISA as the tax benefit is a minimum 25%, albeit with some restrictions,

LHW99

MallyGirl said:

If you also add in salary sacrifice into a pension which save NI (and sometimes even benefits from employer NI saving) then it swings further towards the SIPP side than the ISA side

Although those employers offering salary sacrifice may not be prepared to pay into your SIPP rather than the mony going in to their own company scheme.

Pat38493

Ok but am am missing something to say that rather than focus on it being “only 6.25%”, it ends up being 6.25% of the entire final returned amount achieved, and not a one time 6.25% of the original amount.  Therefore the longer you leave it invested or better returns, the better to have it in a SIPP during that time.

spacemongoose

Thanks everyone for all the quick replies - many interesting observations.

At first I couldn't see where 6.25% was coming from when I was seeing 5%, but I see now:

Although 13.6k and 12.8k are respectively 75% and 80% of 16k,

which is a 5 percentage point difference, 13.6k is 6.25% higher than 12.8k, and that is the percentage I should have been looking at.

Pension being outside of estate for tax is an important factor I hadn't thought about,
as were the points about how tax law could change significantly between the start and end of investment.
And yes, SIPP is more advantageous for high rate tax band, salary sacrifice, and using personal allowance before other pensions kick in, when any of those apply.

Thanks everyone, I'm a lot clearer now1

MallyGirl

LHW99 said:

MallyGirl said:

If you also add in salary sacrifice into a pension which save NI (and sometimes even benefits from employer NI saving) then it swings further towards the SIPP side than the ISA side

Although those employers offering salary sacrifice may not be prepared to pay into your SIPP rather than the mony going in to their own company scheme.

true but you might be able to partial transfer along the way or just transfer to a SIPP on leaving (that) employment