This is part two of a series on how to maximise your ISAs and SIPPs to achieve financial independence. Part One [1] explained why you shouldn’t just target a single Financial Independence ‘number’ when you need to make the most efficient use of multiple tax shelters.
Most people, young and old, should exploit their personal / workplace pension options, from SIPPs [2] to Master Trusts [3], even if they’re aiming for rapid financial independence.
Before I explain why, a quick reminder:
- ISA money is taxed before it goes into your account but not when it’s withdrawn.
- Pension contributions are taxed when withdrawn, but not when they’re put in.
I’m simplifying a little, but essentially that’s the case.
The timeliness of taxation offers no advantage to either ISAs or SIPPs.
An ISA that taxes you at 20% on the way in and 0% on the way out would leave you with exactly the same amount invested as a SIPP that taxes you at 0% on the way in and 20% on the way out.
The maths makes no difference [4] to your investment returns if the tax rates are the same, as The Investor has showed.
But SIPPs beat ISAs and LISAs because the tax rates are not the same.
The comparison below is the simplest way I can think of to illustrate.
Why SIPPs beat ISAs and LISAs for maximizing post-tax returns
In each of the following scenarios, the number in pence is what you have left from £1 gross – once tax is deducted on the way in and/or on the way out.
ISA savings – Basic Rate taxpayer
Each £1 is first taxed at 32% (20% income tax + 12% National Insurance contributions):
£1 x 0.68 (32% tax on way in, 0% tax on way out)
= 68p left
Your ISA leaves you with 68p for every £1 gross you contribute. (Remember, we can ignore investment returns because they will be the same for every account in this comparison, and the timeliness of taxation makes no difference.)
SIPP savings – Basic Rate taxpayer
Each £1 is first taxed at 32% (20% income tax + 12% National Insurance contributions):
£1 x 0.68 (32% tax) = 0.68
But there is tax relief:
0.68 x 1.25 (20% tax relief) = 0.85 (85p is left from £1 gross on way into SIPP)
£0.85 x 0.85 (15% average tax paid on SIPP income after 25% tax-free withdrawal and 20% Basic Rate tax paid on the remaining 75% of income) = 0.7225
= 72p left
So the SIPP leaves you with 72p on the £1, whereas the ISA leaves you with 68p, in a comparison I deliberately skewed against the SIPP.
How skewed?
Well, in reality some of your SIPP income will be withdrawn tax-free using your Personal Allowance (PA). I also haven’t factored in the benefit of salary sacrifice [5] or employer contributions. (I appreciate they’re not available to everybody).
SIPP savings – Basic Rate taxpayer, including Personal Allowance
The SIPP advantage improves dramatically when you account for tax-free Personal Allowance withdrawals of income.
£1 x 0.68 (32% tax) = 0.68
0.68 x 1.25 (20% tax relief) = 0.85
£25,000 income withdrawn from SIPP:
£25,000 x 0.75 (after 25% tax-free withdrawal) = £18,750 taxable income
£18,750 – £12,500 (Personal Allowance) = £6,250 taxable income
£6,250 x 0.2 (20% tax) = £1,250 tax paid
1,250 / 25,000 x 100 = 5% average tax paid on income
£0.85 x 0.95 (0.85 is left from £1 gross on way in, 5% tax average tax paid on way out)
= 80p left
In this scenario, the 80p you get out of a SIPP is worth over 17% more than the 68p dispensed by an ISA. Mileage varies depending on how much you withdraw from your SIPP in any one tax year.
The effect of National Insurance is also interesting here. Tax relief examples generally show 80p being grossed up to £1, or £1 being grossed up to £1.25, to show you how 20% tax relief works. (Just multiply your net figure by 1.25). But much depends on how your pension contributions are deducted.
In a scenario where every £1 gross is down to 68p by the time it hits your bank account, after income tax and National Insurance, then things don’t look quite so good. Put 68p into your pension, multiply by 1.25 and you’ve got 85p. That’s much better than an ISA but salary sacrifice – which enables you to sidestep National Insurance – is a powerful benefit if your workplace offers it, and if your pension contributions would ordinarily be taxed at the Basic Rate or higher.
SIPP savings – Basic Rate taxpayer, including salary sacrifice and PA
Here’s the same scenario again boosted by salary sacrifice:
£1 x 1 (salary sacrifice = no tax on the way in)
£25,000 income taken from SIPP:
£25,000 x 0.75 (after 25% tax-free withdrawal) = £18,750 taxable income.
£18,750 – £12,500 (Personal Allowance) = £6,250 taxable income
£6,250 x 0.2 (20% tax) = £1,250 tax paid
1,250 / 25,000 x 100 = 5% average tax paid
£1 x 0.95 (£1 gross on way in, 5% tax on way out)
= 95p left
Lordy! Now your SIPP funds are worth 40% more than your ISA’s at 95p vs 68p on the £1.
And we still haven’t thrown in employer contributions – in short, just bite their hand off whenever available.
Wealth warning Salary sacrifice can leave low earners out of pocket, and it has wider ramifications for other employment benefits. Check this link [6] for more on salary sacrifice and pension tax relief in general. Salary sacrifice can also be a quagmire for high-earners colliding with the tapered annual allowance [7]. That’s a whole other kettle of articles.
I won’t bore you with all the permutations but here’s another couple of useful examples:
If you took a £50,000 SIPP income in the above scenario, you’d still have 90p on the £1.
Take £50,000 and you’re left at the top of the Basic Rate tax band on £37,500, after deducting your 25% tax-free withdrawal. Deduct another £12,500 for the Personal Allowance and only £25,000 remains taxable at 20%. £5,000 tax divided by £50,000 income means you pay an average tax rate of 10% – leaving you with 90p on the £1.
A Higher Rate taxpayer is left with just 58p on the £1 from an ISA.
What about a Lifetime ISA?
LISA savings – Basic Rate taxpayer
£1 x 0.68 (32% tax on way in)
0.68 x 1.25 (25% gov boost) = 0.85 (0% on way out)
= 85p
LISAs [8] are good for saving for a house but are generally worse than SIPPs as a retirement savings account. You can’t access it until age 60 for retirement without taking a 25% penalty charge, and personal pensions also trump LISAs when you consider inheritance tax, means-testing, and bankruptcy scenarios.
If retiring before the minimum pension age (when you can access your personal pensions) means putting everything you can into your ISAs then forget about your LISA.
If you want to create more tax-free income from age 60 and you’re maxing out your pension’s Annual Allowance, or are worried about hitting your pension Lifetime Allowance then LISAs come into play.
Defined benefit (DB) pensions add another level of complexity, and now is not the time to get bogged down in it. Ultimately DB pensions take pressure off your personal pension, and hopefully the series will give you enough knowledge to see how they fit into your own plan.
There may be some people who discard personal pensions because they aim to retire extremely early, or some other unusual circumstance applies.
But most people will be better off using a personal pension to fund much of their later life from the minimum pension age on.
In the next post [9] in the series, I’ll explain how to work out how much you need to put in your ISA versus your personal pension to hasten financial independence.
Take it steady,
The Accumulator