What is a pension and how does it work?
A pension is a tax-efficient way to save money for later in life. This money is often invested with the intent of growing it beyond your initial saving value. Your pension and any money it contains, will provide an income when you retire.
There are different types of pensions including a personal pension, a workplace pension, a self-invested personal pension (SIPP) and the State Pension. In this article we’ll primarily focus on a self-invested personal pension (SIPP) with a nod to personal pensions.
These pension options are those available for us to personally save in. Workplace pensions are administered by your employer and the state pension is managed by the Government.
We’ll deep dive into the State pension scheme and workplace pensions in other articles, so please check back regularly.
What is a SIPP?
A self-invested personal pension (SIPP) is a flexible type of pension for people who are confident and comfortable with making their own investments. Some people don’t want a pension company making all the investment decisions in their future. A SIPP allows you to save and invest in a diverse variety of investment options, with the aim of creating greater wealth when you retire.
What is the difference between a SIPP and a personal pension?
Both SIPPs and Personal pensions are pensions you pay into privately, outside of your workplace pension. There are some differences between these options as we’ll outline below.
- Personal pensions are administered by a pension fund manager.
- A SIPP is primarily self-managed (the Do-It-Yourself option), however you can always use a regulated financial adviser to help you choose and manage your SIPP. If you invest without advice, you’re unlikely to be protected if things go wrong.
- Personal pensions are primarily provided by insurance companies and banks.
- Personal pensions tend to offer a fraction of the number of investing options when compared to SIPPs.
- The management charges within personal pensions are also often much higher when compared to the investment options SIPPs provide.
How does a SIPP work?
Just like any other pension, a SIPP allows you to save, invest and build wealth for your retirement. A SIPP is personal to you, outside of your workplace or state pensions. It provides a very tax efficient way for you to save over a long term, but also provides you the flexibility to invest where you want.
Anyone who is a UK resident and is under the age of 75 can open and pay into a SIPP. If you have children, a Junior SIPP can be opened for any dependent child.
You can contribute 100% of your annual income (up to the maximum annual allowance of £40,000) to your SIPP each tax year. Children and non-tax payers are also allowed to contribute and gain tax relief. They can make contributions of 80% up to the total earnings within the personal allowance or £2,880 net if their earnings are below this amount.
When can I access my SIPP?
Just like a personal pension, you can currently access your SIPP from age 55. However the minimum retirement age will rise to 57 in 2028 and with this, the age at which you can access your SIPP will increase. Beyond 2028, the age at which you can access your SIPP will remain 10 years below the state pension age.
How many SIPPS can I have?
You can hold multiple SIPPs as there is no limit as long as you are under 75 and a resident of the UK. Many investors choose to do this and open SIPPs with different providers. This may make you feel more comfortable as your investments are spread across providers. Or you may want to access different investment opportunities that a new provider offers.
Any cash in your SIPP is covered up to the current £85,000 limit. If you have cash in multiple SIPPs, each of these are separately covered under FSCS.
Transferring your pension into a SIPP
One of the benefits of a SIPP is that you can generally transfer your defined contribution pensions into it.
Bringing your pensions together will give you more control over your investments, simpler retirement planning and often a wider choice of investment options. It may also decrease your fees payable, which puts more money in your pot over the long term.
When opening your SIPP, you will be asked for the details of your current pension provider(s) that you wish to transfer. You will be asked if you want to transfer your pension as stocks or as cash, though you may not have a choice.
Your SIPP provider will communicate with your pension provider and they’ll begin the transfer. They should keep you updated throughout the process and notify you once the transfer is complete.
What can SIPPs invest in?
Within a SIPP you have a variety of investment options available. Being able to invest diversely can make a huge difference to the return on your investment and increase the amount you will have in retirement. While the investment opportunities differ per provider, your SIPP can invest in the following:
- Funds
- Cash
- Investment trusts
- Shares (UK & overseas)
- Bonds
- Commercial Property
- Open ended investment companies (OEICs)
- Exchange traded funds (ETFs)
- Real estate investment trusts (REITs)
- Commercial property and land (but typically not residential property)
You won’t generally be able to invest in
- Commodities
- Directly-owned residential property
- Buy-to-let property
- Loans
Pros & cons of SIPPs
SIPPs can be a great method for retirement saving and investments, but there are also some drawbacks to consider when deciding to open a SIPP.
Benefits of investing in a SIPP
- You have greater control over your investments
- There are a wider range of investment opportunities
- SIPPs provide tax benefits
- You can bring together multiple pensions within a SIPP
- Those who invest in SIPPs, often find their investments to grow exponentially through the power of compound interest.
Disadvantages of investing in a SIPP
- There are fees for ongoing management and maintenance of your accounts
- Your investments could lose value
- 75% of your balance are subject to income tax on withdrawal
- There is a lifetime allowance to your pension
- If you are looking to retire early in your 40s, the SIPP may not be accessible for 10 or more years.
What are the tax benefits of a SIPP?
Whenever you open a SIPP, there are 2 main types of tax benefit you will be eligible to receive. Firstly, your savings and investments grow free from income tax and capital gains tax. Secondly and equally if not more important, when you pay into your SIPP, you receive government tax relief.
The government will always give you 20% in basic-rate tax relief when you add money to your pension. Even if you don’t pay tax or are a non-earner.
For example, if you added £800 to your pension, the government will add an extra £200 in tax relief.
If you are a higher rate taxpayer, you can claim extra tax relief through your self-assessment. This means that as a higher-rate taxpayer you can get up to 40% tax relief. If you contribute £10,000 to your pension, it could cost you only £6,000.
Make sure to tell your personal accountant about all of your pension contributions throughout the financial year to ensure this is accounted for.
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Does the Lifetime Allowance (LTA) apply to SIPPs?
Yes, the pension lifetime allowance (LTA) also applies to SIPPs.
While there’s no limit to how much you can accumulate in your pension pots. The lifetime allowance currently set at £1,073,100, puts a limit on the total amount you can hold across all of your pensions without incurring additional taxes
If you’ve built up more than the LTA, you will be taxed. The rate at which this is taxed is determined by how you withdraw the savings. For example, if the savings are taken as a lump sum you will be taxed at 55%. This is called the lifetime allowance charge.
You could also keep the money in the pension and take a regular income via the purchase of an annuity or pension income drawdown. In doing so there’s an immediate 25% tax charge. This is on top of any Income tax you pay in that financial year. As a higher rate tax payer, you would expect to pay 40% tax and so the total tax paid would be the same, but if you are a standard rate tax payer, this would leave you slightly better off.
Example: If you are someone who pays tax at the higher rate and you expect to withdraw £1,000 a year as income from your excess lifetime allowance. You would be subject to the 25% lifetime allowance charge and income tax at 40%.
£1000 – 25% lifetime allowance charge – £750 remaining
£750 – 40% income tax – £450 remaining
Total Tax Charge – 55%, the same as taking a lump sum
A standard rate tax payer would be in a slightly better off position
£1000 – 25% lifetime allowance charge – £750 remaining
£750 – 20% income tax – £600 remaining
Total Tax Charge – 40%
How to avoid the lifetime allowance charge
The lifetime allowance charge is completely avoidable for most people. Especially those with SIPPs. Do not be afraid of it and if you exceed your LTA, the worst that can happen is that you pay some tax on it.
However if you want to reduce the opportunity of exceeding the LTA threshold you might consider some of the following strategies:
- Putting those investments such as bonds into your SIPP that have the least likelihood of growth.
- Monitoring your SIPP and knowing when to stop your contributions
- Splitting your savings between pensions and ISAs
- If you are married, you could redirect your retirement savings into your spouse’s pensions
- Retire early
- Withdraw tax-free cash, leaving a lesser fund balance to grow in your pension.
Taking money from your SIPP
Once you reach 55, taking withdrawals from your SIPP is very straightforward and you are able to access the entire pension pot.
Right away, you are eligible to take 25% of your SIPP value as a tax free lump sum (you will need to sell assets to withdraw the sum). The remaining balance of your SIPP is incredibly flexible and you can draw down from it as needed.
Beyond the initial 25% lump sum which is tax free, further withdrawals within your Lifetime Allowance amount are treated as income and taxed accordingly. It is wise to create a drawdown strategy to minimise tax paid. If you pay standard rate tax in this tax year they will be taxed at 20%, higher rate 40%.
Remember you are in control of your SIPP. The freedoms and flexibility it affords also comes with responsibility. Once the balance is gone, it’s gone.
You may of course blow your pension on a Lamborghini or overseas property as Steve Webb (UK Pensions Secretary) suggested might happen in 2014, however data shows that most of those with SIPPs are drawing down their pension pots over time.
What happens to a SIPP on death
When setting up your SIPP, you will be asked to designate beneficiaries in the event of your death. When you die, the remaining value of your SIPP will be passed on to your beneficiaries.
One of the key benefits of a SIPP is that it will be passed onto your beneficiaries free of inheritance tax. You can nominate whoever you like. This could be:
- Your spouse or life partner
- Children or grandchildren
- Wider family (siblings, cousins etc)
- A friend or work colleague
- A charitable organisation
If you want to share the SIPP with a number of different people, you can also designate the percentage you want to leave to each beneficiary. 50% to your spouse or partner, 10% to each child for example.
Any withdrawals they make will usually be tax free if you die before 75. If you die at 75 or older, any withdrawals will be taxed at the income tax rate of the beneficiary.
Who should consider a SIPP?
The question “Is a SIPP right for me?” is often the topic of conversation for business owners and professionals.
The short answer is yes, a SIPP is for you. Its tax benefits make it one of the most attractive saving and investment options. In addition, the ability to choose a wide range of investment types allows you to diversify your retirement savings with the aim of generating greater wealth for your future.
A SIPP is touted for those who are comfortable making their own investment decisions, however with a SIPP you do not have to go it alone.
If you’re not happy choosing your own investments, you can always (and it is recommended that you do) speak to a financial advisor.
Many financial advisors have a long standing experience with SIPPs and will be able to tailor their financial advice to suit your exacting situation. They will help you decide whether a SIPP is right for you, based on a number of factors including:
- Your goals
- Current circumstances
- Risk tolerance
- Market knowledge
- Investment experience
Additional resources
Saving for your retirement can be one of the smartest financial decisions you make. A SIPP may be the right choice for you and depending on your personal circumstances, it will help to ensure your retirement is financially sound. Outside of this site there are some fantastic independent resources to help you make an informed decision.
Money Helper – https://www.moneyhelper.org.uk/en/pensions-and-retirement/pensions-basics/self-invested-personal-pensions
Please remember that the value of your investments can go down as well as up.
Frequently asked questions
A Self-Invested Personal Pension, or SIPP, lets you save, invest and grow your money for retirement. It gives you more flexibility over how you invest.
Yes, you can transfer most types of UK pensions into a SIPP. When opening a SIPP, your provider will ask you to nominate any of your other pensions you want to consolidate in this SIPP. They’ll handle the transfers from your old pension to the new SIPP.
There are no limits to the number of SIPPs you can have. You can have multiple pensions. This includes defined benefit schemes (such as final salary schemes), defined contribution schemes (SIPPs, stakeholder, workplace or personal pensions).
If you die before your 75th birthday and your pension funds are ‘designated’ to your beneficiaries within two years they will be paid tax free. If you die on or after your 75th birthday, the SIPP withdrawals will be tax at the beneficiaries current tax rate.
A SIPP has a wide variety of investment options available that include:
- Funds
- Cash
- Investment trusts
- Shares (UK & overseas)
- Bonds
- Commercial Property
Depending on your SIPP provider, some of these options may or may not be available.
