As you may or may not know, SIPP withdrawal minimum age will be 57 starting from 2028. So I was really angry and wanted to prove myself ISA might be as good as SIPP when it comes to tax efficiency. (Spoiler no it is not)
The methodology and assumptions made for calculations:
we are investing £1000 every month.
We are all in “higher” rate while making contributions (For FY 2021/22 this between £50,271 to £150,000)
we get the basic rate tax refund(+£250) 1 month after our contribution and invest this money immediately,
we get the higher rate tax refund(+£3000) for the year in the 3rd month of the next FY and invest this money immediately
The market is growing at a theoretical 0.6% per month, and this is calculated every month to include the compounding effect of tax returns.
For simplicities sake we started both the ISA and SIPP in July, and contributed £1000 for the next 15 years.
We are below LTA for SIPP
At the end of the 15 years we’ll have assets worth:
SIPP: £476,994
ISA: £322,532
So all of 322K in the ISA is tax free and what we’ll get out of SIPP depends on how we withdraw, so I did the calculations as, withdraw the initial 25% tax free amount completely, and after that withdraw 40K per year. (Again during withdrawal I am assuming tax bands are same as today including 12500 tax free allowance)
Isa Total
322532.02
Sipp Total Net
427945.6149
Sipp Tax Paid
10.28%
withdraw
net
remaining
sipp 25% tax free
119248.7109
119248.7109
357746.13
annual withdraw
40000
34500
317746.13
40000
34500
277746.13
40000
34500
237746.13
40000
34500
197746.13
40000
34500
157746.13
40000
34500
117746.13
40000
34500
77746.13
40000
34500
37746.13
37746.13
32696.904
.
Wanted to share the calculations in case someone is wondering similar questions as myself, and there is a good chance I might have missed something and my assumptions are grossly wrong.
If you see anything odd please point out!
obligatory @Richard.W tag since I know he also likes to dabble in these
Your numbers are probably correct, I think I’ve looked at similar a few years ago, but you’re missing the one advantage of an ISA - you can access your money earlier.
Put simplistically, take the higher rate tax bracket as 40%, and the lower rate at 20%. To complicate things further, you can also withdraw a 25% lump sum from your SIPP tax free at maturity. Assuming zero gains over the years, you can compare the numbers fairly easily.
ISA
Deposit £60
Tax relief: nil
Withdraw £60 - whenever you like.
SIPP
Deposit £60
Tax Relief: £40
Total in SIPP £100
Withdraw - £25 tax free, and £60 at 20% tax, £45 at 40% tax, so able to withdraw £85 or £70 after turning 55.
You are 16-40% better off locking your funds away for the tax relief, which sort of ties in with your numbers.
This looks right to me. When I have looked at this question before I have concluded that ISA contributions are preferred to SIPP for only one type of person, the one who will be in a higher income tax band after retirement than during working life. Maybe 20% then 45%. This might happen if one receives a large inheritance after retirement, has been fabulously successful with investments or deliberately stingy with spending while young.
One also has to think about rule changes. The government may change the rules for either SIPPs or ISAs. Which is most at risk? Will the 25% tax free withdrawal from SIPP persist?
This is the one keeping me awake… With one swoop they changed age from 55 to 57 which is the most important thing for me. Legalities for both can change but I highly doubt there will be like “you cannot access your ISA before 65” sort of change (without risking riots ). Which is the reason I also keep an ISA
if this changes I might become suicidal or homicidal
on a side-note 1: if someone has the budget to contribute to both, the sweet spot for SIPP contributions is 24K per annum (due to 6K limit on tax refund for the higher rate tax band) so the perfectly balanced maximiser might contribute 24K to SIPP and 20K to ISA (I’m aware this is well above our national avg. salary)
on as side note 2: I only changed the following assumption:
to: We are all “basic” rate earner (For FY 2021/22 between £12,571 to £50,270) and, still SIPP is better albeit not as lucrative.
What happens if you are basic rate while earning and additional rate in retirement?* Consider 10000 gross income available to place in ISA or SIPP.
10000 earnings nets 8000 in ISA after 20% tax, suppose doubling to 16000 all tax free to spend.
10000 in SIPP doubling to 20000, taxed on way out to produce 20000 - 0.45 15000 = 13250 to spend. Even higher rate gives only 20000 - 0.40 15000 = 14000
But if trebling rather than doubling, the comparison is 24000 vs 19875 or 21000. The more successful are you at investing the better is the ISA compared to SIPP.
For growth factor f we compare 0.8f to f-(3/4)0.4f = 0.7f for basic rate in work and higher rate in retirement. Albeit this is for marginal top-slice income, ignoring where the money comes from to take you up to higher rate in retirement.
*This scenario is probably rare. But keen investors might aspire to it.
Ps. There are many strange things about the way UK taxes work. Suppose you have 50k pension income, taxed 20% and 40% and 100k dividend income taxed at 32.5%. You take a retirement job paying 1k. This pushes 1k of dividend income above the 150k boundary where it is now taxed at 38.1%. So that 1k attracts an effective tax rate of 40% + (38.1 - 32.5)% = 45.6%, higher than the maximum 45% rate on income.
It can be even worse. The person earning just over 100k has a marginal tax rate of 60% due to the withdrawal of the personal allowance.
yeah this is the thing that’ll effect what you get most actually. The 40K withdrawn per annum was kind of average target for myself, which I assumed would be enough.
But when you say withdrawn at a higher rate during retirement that is a big band of 50k-150k, and there will be a significant tax difference for withdrawing 60K vs 140k albeit both in the same tax band.
on the other hand, earning big does not matter that much in fact is benefiting SIPP as far as I can see. Lump sump investing and doubling/tripling skews the calculations. Investing money over time lets it compound more, with the tax returns.
To test it I’ve plugged in a monthly rate of 3% (which translates to 42.6% annual, which I’d say be a miracle to sustain over 15 years) and SIPP comes still ahead. The difference starts on how much you withdraw. I found the tipping point where ISA becomes better is if you are withdrawing 95K or higher (with little regard to how big/small your earnings are)
Here is the spread sheet, if you are interested in playing with numbers yourself Make a copy and just change the cells painted yellow to your liking.
edit: the results are waaay down starting at row 130ish.
). Which is the reason I also keep an ISA