If there’s one thing governments are good at, it’s taking a simple thing and making it needlessly complicated. Take the Individual Savings Account (ISA). We’ve had the Stocks and Shares ISA, the Cash ISA, the Mini ISA, the Junior ISA, the Lifetime ISA…
I’m 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 don’t 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 won’t be eligible for any more tax when you cash in your ISA, no matter how much you’ve accumulated or what your tax band is.
Capital gains are tax-free too, no matter how much profit you’ve 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%, you’d 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 you’ll get to invest the full £100.
But there is a catch. When you eventually draw down your pension, it’s taxable. So what’s 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 that’s the end of the benefits.
But if you were in the 40% higher rate bracket when you put your cash into your pension, you’d have enjoyed 40% tax relief at the time. And you’ll still only have to pay 20% tax on draw-down, provided you don’t take more than £46,350 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, you’re able to contribute up to £40,000 per year with tax relief, providing the total doesn’t exceed your actual income.
There’s a lifetime limit too, currently of £1.03m, though I’ve 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 year’s savings off to a great start.