TL;DR: A Self-invested personal pension (SIPP) is a tax-advantaged retirement account in the UK. SIPPs give individuals the freedom to invest in a wide range of securities and not just those approved by the company. You must be 55+ years old to withdraw from your SIPP.
One of the major goals most people have in their working career is to save enough money for retirement.
After working for an entire lifetime, people want to relax in their golden years and enjoy the fruits of their labor.
There are several options for saving for retirement in the UK. One of these options is a Self Invested Personal Pension (SIPP). SIPPs are becoming more common as they offer some good tax-benefits and freedom of investing.
We put together this comprehensive guide on SIPPS to answer some important questions such as how SIPPs work, what the tax benefits are, how and when you can access your SIPP and how SIPPs differ from other kinds of retirement plans.
What Is A SIPP?
A SIPP is a special kind of retirement account that workers in the UK can get. With a SIPP, employers contribute a percentage to the account each month, which the employee is free to invest in whatever way they see fit. The employer also matches a percentage of that contribution to the account each month.
SIPPs differ from conventional pension plans in which the provider has ownership and control of the assets.
With a SIPP the member has ownership of the assets and can invest them in whatever way they see fit, hence the “self-invested” part of the name.
In other words, you can look at a SIPP as a DIY pension plan.
With a traditional pension plan, the scheme operator (the employer in this case) invests on behalf of the employee. A SIPP is largely the same, except the employee has a more direct say in where and how the funds are invested. Many people opt for a SIPP for the investing freedom it gives.
SIPPs are generally private pensions in that you set them up yourself.
How Does a SIPP Work?
A SIPP is an alternate third-way retirement account. SIPP contributions are made at a percentage based on the individual’s marginal tax rate. For every contribution, the federal tax agency adds 25% of the contribution to the individual’s SIPP.
SIPP Explained As An Example
So for example, if you are in the 40% tax bracket and make a contribution of £10,000, then the government adds a basic 25% tax relief amount of £2,500.
The investor can claim back £2,500 which means the total tax relief is £5,000.
Given that the highest marginal tax bracket in the UK is 45%, a SIPP can offer up to a 45% tax relief.
In addition to regular work contributions, SIPPs give investors the option to invest a lump sum of their own choosing.
This amount can be as small as £50 or as much as £10,000.
As of 2019-2020, individuals are limited to a £40,000 annual maximum personal contribution.
SIPP Fees and Charges
Like most investment accounts, SIPP accounts have fees associated with them.
A SIPP account may charge a fixed annual fee or they may charge a fixed percentage of the portfolio balance.
Make sure to check if the SIPP account you are opening has commission fees, account fees, or inactivity fees.
In general, you should try to choose a SIPP option with low account fees to best suit long-term investments. In that sense, a fixed annual fee might make more sense than a percentage fee for high-value portfolios.
Account-holders can manage their SIPP funds online by themselves or hire a personal financial manager.
What Can I Invest In With a SIPP?
One of the main benefits of a SIPP is that it gives more flexible investing options.
Traditional personal pension plans are very limited in terms of what they can be invested in.
The full range of SIPP investment options is approved by HM Revenue and Customs (HMRC). With a SIPP you can invest in:
- Unit trusts
- Investment trusts
- Exchange-traded funds (ETFs)
- International stock
- Government bonds
- Corporate bonds
- Other fixed interest securities
SIPP investing gives more flexibility but comes with extra responsibilities.
With a SIPP, you will be responsible for researching and spending time managing your assets.
Moreover, with a SIPP, the scheme holder is not responsible for portfolio performance.
In a traditional pension plan, the pension holder is entitled to certain benefits regardless of the scheme’s performance in the market.
With a SIPP, if you make the wrong investment decision, you have to deal with the consequences. That is why SIPPs are recommended primarily for those who have some experience investing on their own.
If you want the peace of mind of not having to manage your investments, then a traditional personal pension plan might be your best option.
How Do I Access My SIPP Fund?
Since SIPPs are retirement accounts there are age restrictions on when you can access its funds.
In the UK, you must be at least 55 to make withdrawals from your SIPP account.
Of course, this does not mean you have to start making withdrawals at that age, only that you can if you want.
You don’t even have to withdraw from your SIPP when you actually retire. Discretion on accessing funds is left entirely to you.
In rare cases, you might be able to access your SIPP funds before the age of 55, but you will likely incur harsh penalties for doing so.
In most cases, HMRC will tax funds withdraw at 55% if they are taken out before the requisite age, so any attempt to use your SIPP before 55 will likely be costly and not worth the effort.
When you can withdraw your funds, you have a wide range of flexibility. You can withdraw the entire amount as one lump sum or you can schedule regular withdraws to act as a monthly income.
SIPP Taxes on withdrawals
Generally, you are able to withdraw up to 25% of your SIPP account tax-free.
So if the total value is £100,000, you can take out at least £25,000 without paying any taxes.
You can take that all in a single lump sum or you can make 25% of each drawdown payment made tax-free.
Regardless of how you decide to tackle it, you will have to pay taxes on the remaining 75% of the fund. Withdrawn funds after the 25% mark are taxed as regular income based on your marginal tax rate.
You might be tempted to take your entire SIPP fund in one fell swoop. First off, 75% of your funds will be taxed as income.
If you take out the entire value at once, there is a very good chance you will jump up a tax bracket and have to pay a higher tax rate—up to 45% income tax.
In that sense, it is usually a smarter idea to withdraw smaller amounts to lower your overall tax liability.
What can I do with my money?
It’s your money so you can do whatever you want.
There are no general restrictions on the usage of SIPP funds. You can spend it all, put it in a traditional savings account, invest it, or even turn it into cash and create a Scrooge McDuck pool of bills and coins to swim in.
Ok, we’re kidding about that last part (kind of), but the basic point is you can do what you please with your SIPP funds.
What Happens to My SIPP When I Die?
If you pass away with remaining funds in your SIPP, then those assets pass to your nominated beneficiaries.
When setting up a SIPP, you are required to mark down intended beneficiaries by filling out an expression of wish form. Trustees ultimately hold the final say in who death benefits are paid to, but they guide their decision based on your wishes.
Exceptional circumstances or legal challenges may affect the final decision of who benefits are paid to.
Death benefits can be handled the same way as withdrawals. They can be allocated in a single lump sum or they can be used as an ongoing pension for an income.
Death benefits are normally tax-free and are exempt from inheritance taxes.
If you die before the age of 75, there is usually no income tax liability.
If you pass away after 75, then death benefits are subject to taxes at the beneficiary’s income tax rate.
What if my beneficiary dies?
If your intended beneficiary dies, then the exact same thing happens as when the original plan holder passes away.
SIPP funds can be passed down to an unlimited number of beneficiaries until the account is empty.
Once again, income tax is determined upon the age of death of the beneficiary and the tax status of the new recipient.
SIPP Pros & Cons
Now that we have a solid overview of SIPPs, let’s talk more explicitly about their pros and cons.
The main benefit of a SIPP over a traditional personal pension plan is you have more control over where assets are invested.
Individuals SIPP holders can choose which shares, bonds, and commodities to invest in.
With a traditional personal pension plan, these decisions are made by the scheme holder, not the individual trustee.
Traditional personal pension plans also have a much more limited range of investment options. These investments are made by the scheme holder with little to no input from the trustee.
Greater potential returns
Traditional pension plans normally invest in very low-risk securities to achieve stable growth.
In general, this is a good idea for retirement plans as you want your retirement funds to be secure and stable. However, since SIPPs give individual investors more flexibility, there is greater opportunity to make gains on investments.
Individual investors can modify their investment strategy to their own risk-tolerance and invest in higher risk/higher reward securities.
SIPP also offer attractive tax benefits.
First of all, your investments will be free from any capital gains taxes and income taxes.
Second, you get government tax relief every time you contribute to your SIPP.
Every time you make a contribution, the government adds 20% of that contribution to the top. So if you invest £1,000, they will add £200 for a total of £1,200.
If you are in a higher tax bracket you can also claim extra tax relief. The extra tax relief makes up the differences between the 20% base relief and your income tax bracket.
If you are in a higher tax bracket and invest £10,000, then the government adds £2,000 on the top and you can receive a £2,000 rebate from HMRC.
In other words, the total cost of that £12,000 investment is actually only £7,000 when you factor in relief and rebates.
Keep in mind that you can’t really benefit from these tax advantages until you are at least 55. If you take out money before that age, you will have to pay a hefty 55% tax on whatever funds you take out.
Lower tax on withdrawal
Conventional SIPP funds allow you to withdraw up to 25% of their amount completely tax-free.
The other 75% is taxed as normal income on your tax bracket. This is one reason why making smaller withdrawals is a smart idea.
Small withdraws have a better chance of keeping you in the same tax bracket so you can take out a bit, pay a lower tax rate, and keep the rest to take out later at that same low rate.
If you take it out all at once, you will likely jump up a tax bracket and have to pay a larger percentage in income taxes.
Withdrawal options are also flexible. You can withdraw as a lump sum or set up monthly withdrawals to act as a source of passive income.
Can be passed to beneficiaries
SIPPs also offer flexible beneficiary rules. You can essentially markdown whoever you want to be a beneficiary, and if you pass away, the remaining value of your SIPP fund passes directly to your stated beneficiary. Any wealth passed to beneficiaries is generally exempt from inheritance taxes, barring extenuating circumstances.
Since you are managing your funds yourself, you are responsible for any losses you might incur from bad investments.
With traditional pension plans, the scheme holder is generally responsible for providing benefits to trustees regardless of the state of the investment.
Since they handle all the investments, they are required to compensate the trustee even if those investments don’t do so well.
With a SIPP, you don’t have any such protections.
Since you are making the investment decisions, you will have to deal with the consequences of any bad investment decisions you make. So while there is the potential for greater reward, there is a simultaneous greater risk using a SIPP.
Limit on tax relief
SIPP also have an upper limit on how much tax relief they can give.
SIPPs are limited to tax relief on total contributions under £40,000 per year.
That means if you contribute more than £40,000 to your SIP in one year, you won’t get any tax relief on that 40,001st pound and beyond.
Also, the maximum percentage rebate you can get is 45% which coincides with the UK’s highest marginal tax bracket for individuals.
Can’t access till 55 or older
This is not so much a con as it is a necessary part of pension plans. SIPPs are locked until you reach the age of 55.
Once you hit that age, you can withdraw funds to your heart’s content, but you are ineligible to access those funds before then.
On the rare occasion that your scheme holder allows you to access SIPP funds before the age of 55, you will most likely incur harsh tax penalties up to 55% of the withdrawn value.
Potential for SIPP scams
Unfortunately, pension scams are on the rise in the UK and so are SIPP scams.
Given that SIPPs are a relatively new pension option, there is relatively little regulation surrounding their operation, or at least, fewer regulations than traditional pension plans.
There have been a few notable cases in the UK media of SIPP companies selling fraudulent investments under the moniker of “SIPP compliant”.
As the rules regarding the responsibility of SIPP portfolio performance are not clearly defined as of yet, scam SIPP companies can sell bogus investments to individuals, and when those investments inevitably tank, they can claim no responsibility and investors lose out.
Is a SIPP Right for Me?
You should consider starting a SIPP if…
You have experience with investing
SIPP plans are best suited for mid-to-high earning individuals who have previous experience investing and managing funds. If you have good experience making investments and you want more freedom with your pension plan, a SIPP scheme could work for you.
You are a high net-worth individual
SIPP accounts are good for investors as they give more flexibility in investment decisions. They carry more risk though. If you are a high net-worth individual, then odds are you make enough that any hits you might take to your SIPP portfolio can be easily offset. SIPPs are more useful if you contribute more than the monthly minimum as well so those with more disposable income are in a better position to grow SIPP funds.
You want flexible investing
Again, the main benefit of SIPPs is that they give more flexibility with making investments. If you want more hands-on control of your retirement accounts, a SIPP might be a good idea.
SIPPs are still pretty new in the world of pensions so we will need a bit more time to see how they manage in the long run and if they are a suitable alternative pension plan. For now though, if you want more flexibility and autonomy over your pension investment decisions, then a SIPP might be the right option for you.