Save For Retirement Using Existing
Tax Shelters

The best places to save for retirement are in tax favourable retirement accounts such as individual savings accounts ("Retirement ISAs") and self invested personal pensions ("SIPPs").

Both types of accounts have different features - advantages and disadvantages, the key difference is whether you get tax relief going in (SIPP) or coming out (ISA income paid out is 100% tax free). However, SIPPs lock your money away till your mid 50's, while ISAs cannot hold shares listed on the Alternative Investment Market.

SIPPs as a vehicle to save for retirement

Let's start with SIPPs. Disillusioned with traditional pension plans, many investors have transfered their existing pensions to SIPPs so that they can continue to save for retirement while being in full control of their retirement funds.

With SIPP's, you get tax relief on your contributions which is hugely beneficial when you save for retirement. In effect, this gives you back the tax you've already paid on earned income. Thus, basic-rate taxpayers get 20% tax relief, which turns an £80 contribution into £100 on day one. Higher-rate taxpayers within certain limits get 40% tax relief.

The contribution limits for SIPP's are among the highest around. Compare this with an ISA, where you can't contribute more than £10,200 per tax year.

SIPPs for babies, children and other non-earners, including non-working spouses

Anybody is entitled to tax relief on pension contributions even if they aren’t working or paying tax. They, or their partner or parent(s), can put up to £2,880 into a pension such as a SIPP each year, and the government will pay in up to £720 in tax relief.

This has opened up the way to start a SIPP for newborns, children and other non-earners.

You enjoy tax-free capital appreciation on any investments within your SIPP. Also, most of the income earned by these investments (with a few notable exceptions, including share dividends) is also completely tax free.

SIPPs can hold a wide range of different stocks and shares, including those traded on AIM and overseas. Importantly, you do not pay any Capital Gains Tax on any profits generated within a SIPP!

The main (perceived!) drawbacks to SIPPs are:

  • from April 2010 onwards, once in, your money must remain inside the SIPP until you turn 55, and
  • when you do decide to retire, there are limitations on how you collect your money (for example, only 25 per cent can be returned as a lump sum). So SIPPs are not that flexible.

To me, this lock-in period, till your mid-fifties at the earliest, is a good thing, because it clearly earmarks this money solely for retirement income purposes, allowing it to grow over many years.

It also avoids the temptation to dip into your SIPP before time. Similarly, at least 75 per cent of your pension portfolio is earmarked for subseqent income in retirement.

What income generating investments can you put in a SIPP?

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ISA's as a vehicle to save for retirement

Now to ISAs. As with SIPPs, a key attraction to ISAs is being able to shelter your selected stocks and shares entirely from CGT.

With an ISA you don't get tax relief on your contributions which is unfortunate when you save for retirement. Furthermore, the annual contribution limit amounts to £10,200

However, in one aspect ISAs do offer much greater flexibility than SIPPs: tax-free withdrawals.

You can withdraw part or all of your money (including the income generated from your investments within your ISA) out of an ISA whenever you want (due to the annual contribution limits you may not be able to return any or all of it back to the ISA straight away). The main drawback to ISAs is they cannot hold AIM shares.

ISAs are simplicity itself: you put your post-tax(!) money in, and in most cases, it grows tax-free. You can withdraw what you like tax-free, when you want. However, the ability to withdraw any or all monies out of an ISA is also its greatest danger if you are saving for your retirement via an ISA, and you need cash quickly for whatever reason. Try to resist!

SIPPs, ISA's and Capital Gains Tax

We can't cover SIPPs and ISAs without touching upon Capital Gains Tax ("CGT"). Essentially if you hold any share in a standard share dealing account instead of a SIPP or ISA, then, one day, you may become liable to pay capital gains tax on your profit.

Thankfully everyone enjoys a CGT allowance, which for the current 2010/11 tax year is £10,100. So if you do sell shares within an ordinary dealing account and your total gain is £10,100 or less in the current tax year, you won't need to pay CGT. Note that only 'crystallised' gains are assessed for CGT. 'Paper' gains on shares yet to be sold are excluded.

If, however, your gains within an ordinary sharedealing account do exceed £10,100 in the current tax year, then CGT could be payable.

Click Here for a more in-depth look at capital gains tax and ways to avoid it altogether.

Be flexible - if you can - do both a SIPP and an ISA!

Overall SIPPs and ISAs are very useful investment vehicles when saving for retirement. Both are tax efficient in their different ways, though neither is entirely perfect - the key difference is whether you get tax relief going in (SIPP) or coming out (ISA).

I would say, in general, if possible, it makes sense to spread your money between SIPPs and ISAs. If one vehicle becomes onerous due to regulation changes at the Government's whim you can always fall back on the other.

I'll not try to offer some precise formula for determining the split between SIPP and ISA contribution. It all depends on your personal circumstances.

Unless you're retiring anytime soon (say, within the next three to five years or so), I am sure it's all bound to change again anyway, rendering precise calculations useless. And if you are retiring shortly, you need specialist advice in any case.

Instead, I'd suggest spreading your money between the two retirement investment vehicles, wrapping them around cost-efficient investments, re-investing dividends, and concentrating on the balance between living today and saving for tomorrow.

By the way, some of your (tax-free) ISA money can always be moved into a SIPP (gaining tax relief!) should it look worthwhile in years to come – whereas the opposite isn't true.

And, yes, you'll still be called a pensioner if only half your retirement pot is in tax-free Retirement ISA. But at least you'll have some of the freedom that the old so envy in the young.

Finally, we should reiterate that we've only touched on the basics of the current tax rules here. These are subject to change, often at quite short notice. Particularly if your personal tax situation is more complex, it may be worth getting some professional advice.

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