ISAs and SIPPs are both great products to help save for the future. However, while these products do have some similarities, they are very different.
For example, investors can only contribute a maximum of £20,000 into an ISA every year. Meanwhile, SIPP contributions are effectively capped at £40,000 a year as any contributions above that level attract tax penalties.
SIPP contributions also attract tax relief at your marginal tax rate. That’s 20% for basic rate taxpayers. So, for every £80 contributed, the government will add an extra £20 to take the total to £100. These additional contributions may decrease the time it takes to make a million.
That said, while you can put more money away every year using a SIPP, the product has some drawbacks, which means it might not be suitable for all investors.
ISA benefits
The biggest drawback of using a SIPP is the fact that money cannot be withdrawn until the owner is 55 years of age. What’s more, you can only take out a 25% tax-free lump sum. Any money withdrawn after that is taxed at your marginal tax rate.
On the other hand, money put into an ISA does not warrant any special tax treatment. You can take the money out whenever you want, and don’t have to worry about incurring any additional tax liabilities. So-called flexible ISAs also allow you to take out and put in as much money as you want every year as long as you do not breach the £20,000 limit.
As such, if you want total control over your money, an ISA may be the best product to use to make a million. However, the tax benefits that come with a SIPP suggest that it will make you a millionaire first.
Investing for wealth
The best way to invest your money in one of these tax-efficient wrappers could be to use a FTSE 100 tracker fund. Over the past three-and-a-half decades, the FTSE 100 has produced an average annual return in the region of 7%. At this rate of return and paying in the maximum amount, it would take just 15 years to build a £1m nest egg using a SIPP, according to my calculations. To reiterate, that’s assuming an average annual contribution of £40,000, although that wouldn’t be possible for many savers.
With contributions limited to just £20,000 a year, it would take 22 years to reach the same target in an ISA from a standing start.
It may be possible to reach this target even faster using individual shares. Now could be the perfect time to buy a diverse portfolio of undervalued FTSE 100 stocks after the recent stock market crash. Many blue-chip companies are trading at depressed levels, which reflects the uncertainty hanging over the global economy.
Clearly, these companies are unlikely to generate substantial returns in the near term, but over the long run, the market should recover from its recent setback.
As investor sentiment improves, that could mean significant returns for investors buying today with a long-term outlook. If these stocks are owned in an ISA or SIPP, there will be no capital gains tax to pay when it is time to sell.