Bridging to Retirement – Splitting SIPP & ISA Contributions

Edit 06Dec21: I realized that this is all completely wrong! You can get the same effect, without paying National Insurance, by just putting part of the money to the pension, then taking the 62% hit on the take home cash for an ISA.

For example, for £1,000 of pre-tax income, put £475 in your salary sacrifice pension. Pay 62% tax on the £525 remaining, for a take home of £199.50 – then put that in your ISA. That’s £674.50 invested and £325.50 in tax – 32.55% effective tax rate, better than the 33.5% if you use a SIPP. In retirement, that’s £199.50 you can access anytime and £403.75 (after 15% tax) from your pension, total of £603.25, for a 39.675% effective tax rate.

I’ll leave up the original, because the overall analysis of pension vs ISA is still valid – all the numbers just tilt slightly lower the pension you use because you save NI. But avoid all the hassle of a SIPP and just salary sacrifice. Sorry!

Original Post: This will be a fairly nerdy post that only applies to a small niche – fair warning! But if you’re interested in early retirement, the personal allowance taper, and/or the lifetime allowance, it might be interesting. I’ll also note this applies just as much to non-US citizens, nothing US specific here, it’s all UK rules.

Three common topics come up in UK FIRE circles:

  1. How to “bridge” from early retirement to the age where you can access a workplace pension and/or SIPP (currently 55, changing to 57, may well go up more in the coming decades).
    • For readers familiar with this discussion in US FIRE circles, the UK situation is complicated by the fact that there is realistically no way of accessing a pension early, barring terminal illness (which kind of defeats the point…). This contrasts with Roth ladders, 72(t) SEPP, etc. for the US. But at least ISAs have no age limit at all!
  2. How to avoid the 62% tax trap between £100k and £125,140
    • That’s 40% income tax, 2% National Insurance (rising to 3.25% next year, for a 63.25% marginal rate), and the Personal Allowance reduction of £1 for every £2 of adjusted net income over £100k, such that the £12,570 allowance drops to zero at £125,140 income.
    • In simplified terms, Adjusted Net Income is your total taxable income (wages, interest, dividends, self-employment profits, some benefits, some rental income, etc.), minus pension contributions and gift aid donations.
  3. How to avoid exceeding Lifetime Allowance (LTA) and paying the 25% penalty on a total pension value exceeding £1,073,100.

As a general rule, it is more tax efficient to make pension contributions than ISA contributions, due to the relief of income tax on pension contributions, plus the NI relief if it’s a salary sacrifice pension. Nothing I’m going to say changes that – the best way to keep as much of your money as possible is to salary sacrifice it into a pension – and you should always* take advantage of any employer match. That’s even more true at the 62% marginal rate – you can either put £1 in a pension or take 32p home and stick it in an ISA (or a taxable General Investment Account, GIA).

However, if you’re concerned about building an early retirement “bridge” and/or about exceeding the LTA, you want to think about how to manage both pension and ISA/GIA contributions to meet those objectives – basically, how to reduce pension contributions but not let HMRC take too much of your money.

*Somebody will find an edge case where you are better off without an employer match, but it’s extremely rare.

SIPPs vs Workplace Pensions

SIPPs and workplace pensions are very similar. But there are a couple of key differences that matter here:

  1. When you salary sacrifice into a workplace pension, 100% of your sacrifice goes into the pension. £100 sacrificed = £100 in your pension, no tax withheld.
  2. But when you contribute after-tax dollars to a SIPP as a higher or additional rate taxpayer, the situation is a little funky:
    • Your pension provider provides the first 20% of tax relief to you directly in the SIPP, increasing your contribution by 25% (20% tax on £125 is £100, so if you contribute £100, they’ll top up to £125)
    • To get the remaining tax relief – which could be another 40% if you’re a higher rate taxpayer in the Personal Allowance phase out – you need to ask HMRC, typically via a Self Assessment (if you’re not otherwise required to file a Self Assessment, you can just contact them for the refund – you’d have to get your net adjusted income completely under £100k, since that’s one of the triggers for filing a Self Assessment).
    • When you get the tax relief back from HMRC, it’s cash – not deposited to your SIPP, just real money in your current account. You could choose to put that cash in your pension (and then get more tax relief next year, since money is fungible and that cash could effectively come from after-tax income), or you could put it in an ISA or GIA. This cash is the key difference between a SIPP and workplace pension, for our purposes today.
  3. Also worth noting that salary sacrifice saves you NI, while a SIPP doesn’t allow you to claim the NI back. Only 2% (to 3.25%) for higher and additional rate taxpayers, but it’s money that’s gone for good.

Splitting After Tax Cash to SIPP & ISA

Given what we know about getting cash tax relief on a SIPP, this opens an interesting possibility. Let’s compare three scenarios – we’ll assume your adjusted net income is within the Personal Allowance phase out, none of this makes much sense in any other bracket. For a simple example, this is all wage income and your wages minus any existing salary sacrifice pension contributions brings you in the £100k to ~£125k range:

  1. Salary Sacrifice: you sacrifice an additional £1,000 to your pension, resulting in £1,000 pension balance. In retirement, this will be taxed – let’s say a 20% tax on the 75% taxable portion, resulting in a final value of £850 (ignoring investment growth and inflation – we’ll take those as constants for all three scenarios). 15% effective tax rate.
  2. ISA only: your £1,000 of taxable pay becomes £380 of take home cash. You contribute all £380 to an ISA. The ISA is tax free forever, so that’s £380 in retirement – less than half of what that £1,000 would be worth in a pension, but you can access it whenever you want. 62% effective tax rate.
    • Reminder for US citizens: ISAs are not US tax advantaged and you should not hold PFICs in them! Individual stocks only.
  3. SIPP + ISA: take that £380 take home cash and contribute it to a SIPP. Your pension provider adds 20% tax relief, so you have £475 in your SIPP. When you file your UK taxes, you claim back the remaining 40% of tax relief (20% from your 40% higher rate band, and 20% from the Personal Allowance phase out) – that’s £190 cash. You then contribute that £190 cash to an ISA. In retirement, that’s £190 you can access anytime and £403.75 (after 15% tax) from your SIPP, total of £593.75, for a 40.625% effective tax rate (33.5% at contribution)

33% tax today plus more on pension withdrawals for a total of 40.625% isn’t great, but it’s very nearly the same 42% you pay on income under £100k, without the Personal Allowance taper. So splitting between a SIPP and ISA gets you in the same tax position as using after-tax cash in the 42% bracket completely for an ISA, but with the drawback of locking about 2/3 of it away until pension age.

A Spectrum of Options

Scenario 3 above uses all of your cash for a SIPP and then an ISA, but you don’t have to. If you want more in the ISA, you contribute less than the £380 per £1,000 to the SIPP, and put the balance in your ISA. Equally, you can save more tax by putting more than £380 in your SIPP – you’ll have to effectively borrow from yourself until you get your refund from HMRC.

You can pick any option, from 0% SIPP and 100% ISA, to 100% SIPP and -2% ISA (since you still have to pay NI, you could withdraw cash to do that – although at that point you should just salary sacrifice and save the NI).

I tried a couple ways to visualize this – the first comparing the three places that £1,000 can go: tax, SIPP, and ISA. X-axis is the amount contributed to the SIPP, from £0 (everything to tax and ISA) up to £800 (above £800 and you’re basically just taking cash/ISA to pay income tax – go for salary sacrifice at that point). Y-axis is the value in each account: SIPP, ISA, and tax (so in the Government’s account, not yours!):

There are no kinks or inflection points – the more you put in your SIPP, the less you pay in tax, and the less you can access early.

The other way to look at it is how your total investment changes depending how much you contribute to your SIPP:

Again, no kinks or inflections – the more you put in your SIPP, the more you have invested (because the less you pay in tax).

I’ll paste the same charts at the end, but with 15% tax on the SIPP balance – it doesn’t change the conclusion at all.

So What?

I’ll reiterate that the best way to reduce taxes is via salary sacrifice to a pension. That said, hopefully this shows that there is a middle ground blending a SIPP and ISA to reduce taxes to a fairly reasonable level while also making some money accessible early, and reducing the impact of the Lifetime Allowance.

I’m in the very fortunate position that, if my employer’s year-end results are good, my annual bonus will probably just push me into the 62% bracket. I will wait to see how far into the bracket I go, but I’m definitely considering the SIPP + ISA option. What do you think, is this something that might be useful to you?

Assumptions & Clarifications

Didn’t want to clutter up the body of the post, but for the especially nerdy, there are some assumptions above that might matter for specific situations, and a few nuances I deliberately ignored:

  • I’ve assumed that SIPPs are an appropriate investment for a US citizen in the UK (although everything above would also apply equally to a non-US citizen). That means it’s treated as a “pension” per the treaty and you can effectively invest in it (the “pension” designation protects any PFICs). Whether or not you need to file form 3520/3520A doesn’t affect the analysis, although it’s a pain if you decide it is required.
  • Employer match is already maxed out and you don’t get any payment for the employer portion of NI. If you haven’t already maxed your employer match, obviously do that first. If your employer contributes some of their NI, that would push the balance towards the salary sacrifice pension.
  • Real returns are the same in a pension or ISA – given the restrictions on US citizens investing in ISAs, this is a big assumption. The analysis would still hold completely true if you used a Roth IRA (with some restrictions on early access), and mostly true if you used a taxable brokerage account as long as you manage capital gains and dividend taxes (both US and UK taxes involved).
  • You’ve still got room in your ISA to contribute. If ISA is maxed, then Roth IRA or taxable GIA as above.
  • 20% income tax on SIPP withdrawals is a rough assumption. It assumes no Personal Allowance (it’s all used by State Pension, Social Security, or other income – likely to be roughly true) and that your income doesn’t push you into the 40% bracket.
  • Assumed you’re still staying under the £40k pension annual allowance, combined for all SIPP and salary sacrifice pension contributions.
  • Instead of having a refund of the remaining 40% pension relief from HMRC, you could get the refund one year and then adjust your tax code so you get the cash spread through the year, and could do ISA contributions earlier. That’s mathematically better (time in the market and all that), but more complicated if your income isn’t stable, you’ve got significant variability in bonuses, paid on commission, that kind of thing.

Charts & Data

Account balances, assuming 15% tax on the SIPP in retirement:

Total investment, also with 15% SIPP tax

And if anybody wants the spreadsheet data (easier to pick out individual values), I’ve made a copy in this Google Sheet.

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