Which is better, an Isa or a Sipp? The truth is that self-invested personal pensions are more tax-efficient than individual savings accounts, but Isas are more flexible. However, a good retirement strategy will include both types of savings account.

What are the tax differences?

The Sipp is more tax-efficient because you receive tax relief on your contributions. The government grosses up pension contributions according to your tax band. This is done automatically for basic-rate taxpayers, but higher-rate taxpayers need to claim back their extra relief separately. 

Note too, non-taxpayers also receive 20 per cent basic-rate relief (up to £3,600 gross). Grossed up, basic rate and non-taxpayers making a net contribution of £1,000 receive £1,250, higher-rate taxpayers £1,667, and £2,000 for those on 50 per cent.  

However, tax is payable when an income is taken from your Sipp. In comparison, an Isa gives you no tax relief on the way in, but the proceeds are free of tax.

A Sipp is also more tax-efficient than an Isa for two additional reasons:

• You can take 25 per cent of your Sipp as a tax-free lump sum

• You are likely to pay less tax in retirement than while you are working. This is particularly true for higher-rate taxpayers who receive 40 per cent tax relief on their contributions but will probably only pay 20 per cent tax on their pension income in retirement. 

You currently need an income of £43,875 to be a higher-rate taxpayer. ‘To generate a retirement income of that level you would need pension savings of approximately £1.1 million,’ calculates Laith Khalaf, pensions analyst at Hargreaves Lansdown. ‘Relatively few pensioners are therefore 40 per cent taxpayers in retirement, with the possible exception of super-taxpayers who receive 50 per cent tax relief on their contributions now. Even basic-rate taxpayers will pay less than 20 per cent tax on a large chunk of their income in retirement because the first £9,490 of your income is tax-free if you are over 65.’ 

But aren't Isas more flexible?

Yes. Isas are more flexible because you can draw income at any time. You can only draw from a Sipp from age 55, and only 25 per cent can be taken as a tax-free lump sum. 

However, under new rules, from April, if you have another secure source of pension income worth £20,000 a year or more, then you will be able to use a new flexible drawdown option to take money from your pension as frequently, or infrequently, as you want.

What is the impact for different tax brackets?

The tax rate table (below) shows the value of your pension fund after it has been taxed at your marginal rate in retirement. The figures represent the after-tax value of a £10,200 initial investment after 25 years, assuming 6 per cent growth after charges.

Difference in tax rates

Source: Hargreaves Lansdown

Without a change in your tax status following retirement, returns from Isas and Sipps converge, as the returns table (below) shows. Here, you can see that the real winner is the non-taxpaying Sippholder who receives a 25 per cent enhancement on contributions, but doesn’t pay tax on pension income post-retirement.

Returns from Isas and pensions

Source: Candid Money. Figures based on current tax rates, these could change in future

What about inheritance tax?

In this respect the Sipp is the winner, because its proceeds fall outside of your estate, whereas Isa proceeds do not and are therefore potentially liable to inheritance tax. 

Are there any other potential considerations?

Pension income could be eroded if income tax rates rise in future. Another advantage of Isas is their income doesn’t need to be entered on a tax return, so it doesn’t count towards the limit for the increased age-related personal income tax allowance available to those aged 65 and over.

‘For most of us it makes sense to use both pensions and Isas when saving for the future,’ says Justin Modray, founder of Candid Money. He adds that the extent to which you use one over the other will depend on how you think your tax status will change over time and how much flexibility you need.