MT Finance - How Does a SIPP Work?

Pensions can be a highly effective way to make investments for retirement, due to the generous tax relief on contributions - let’s find out how a SIPP works.

A SIPP stands for Self-Invested Personal Pension and works in a similar way to a standard personal pension, allowing you to save, invest and build up a pot of money. However, SIPPs typically give you a much wider choice of investments, which means you can invest in the way that suits you while harnessing valuable tax relief on the money you pay in.

Tax relief is a hidden investment superpower. It can mean, for instance, that the cost of a £1,000 pension contribution is as little as £550. The government tops up whatever you contribute with 20% basic rate tax relief, while higher-rate and additional-rate taxpayers may claim up to a further 20% and 25% respectively.

Key Features of a SIPP

1. Holds a Wide Range of Investments

Most pensions only have a narrow range of investment options, which may be fine for less hands-on investors. However, if you are looking to maximise the range of possible investments a SIPP may be worth considering. Many providers will offer a range of different investment choices, including direct UK and overseas shares, bonds, and gilts (UK government bonds), funds, investment trusts and exchange traded funds (or ETFs).

2. Makes Use of Annual Tax Allowances

Your total pension contributions, including those paid by your employer, are subject to an ‘annual allowance’, which is usually £40,000 gross, though following announcements in the Spring Budget this will rise to £60,000 in the new (2023/24) tax year. You are also restricted to paying in no more than 100% of your relevant UK earnings - essentially earned income rather than any other form of income such as dividends or interest.

Very high earners get a lower annual allowance, which could limit their maximum contribution to as little as £4,000 a year - but this is rising to £10,000 in the 2023/24 tax year. The rules on when this ‘tapered’ annual allowance kicks in are complicated. Very broadly, it could affect people with income and benefits of more than £200,000 a year.

If you haven’t used your full annual allowance from up to three previous years, you might be able to carry it forward and use it in the current tax year provided your earnings are high enough and you have been a member of a registered pension scheme in those preceding years. Additional guidance and examples can be found on the government’s Money Helper website.

3. Most UK Residents Are Eligible for a SIPP

You are eligible to open a SIPP account if you are a UK resident under the age of 75. You may contribute to as many pensions as you like simultaneously, but please be aware of the pension allowances described above.

You can pay money in when it suits you, either through lump sums or monthly via direct debit. It is also possible to arrange for your employer to make contributions to your SIPP if they offer that flexibility.

If you are currently contributing to a workplace pension, your employer will be contributing too. You should prioritise this form of pension saving to take full advantage, but you could consider a SIPP for extra pension provision.

4. Flexible Pension Withdrawals

Unlike ISAs, personal pensions including SIPPs don’t allow you access to your money until retirement age, which at the earliest is 55. This is set to rise to 57 in the future, and the rules can always change. You then have a number of options. Lump sums or a series of lump sums can be taken at any time, with the first 25% able to be taken tax free and the remainder taxable.

Alternatively, you can use the pot to buy an annuity, a product that provides a guaranteed income, also taxable, for the rest of your life. This can be attractive for those who require a secure income and do not wish to take investment risk with some or all their pension. Annuities can also be tailored to particular circumstances, such as providing a spouse’s pension on death and there are special, higher rates for smokers or those with health conditions. When buying an annuity with your pot it pays to shop around.

5. Credits Tax Relief Based on Your Contributions

Contributing to pensions has the effect of reducing your overall income, and therefore tax burden. When you make a SIPP contribution, your provider will then credit your pension with basic rate tax relief, usually within a short timeframe. The tax relief will be applied as cash to your account as soon as it has been received from HMRC. You must claim higher and additional rate tax relief for yourself via your tax return or by contacting HMRC.

6. Can Hold Existing Savings When You Transfer Pensions

Over the years you may have collected a variety of pension schemes, especially if you have had several jobs. For those who dislike the clutter of a mixture of pensions, consolidating many types of pension schemes into one modern pension can be a relatively straightforward exercise.

A ‘defined contribution’ scheme, such as a personal pension, can usually be moved to another, similar scheme easily, making tidying up these pensions simple. You can typically transfer a range of different schemes; however, you should always check for any exit penalties when considering a transfer.

There can be more significant pitfalls too. If your pension has ‘Safeguarded Benefits,’ which includes Final Salary or Defined Benefit pension benefits, Guaranteed Annuity Rates and Guaranteed Minimum Pensions, you cannot transfer without a positive recommendation from a regulated advisor. Schemes with these features require regulated advice before transferring and are almost always best left untouched.

Graham Austin,

Chartered

FCSI Investment Director

Graham.Austin@charles-stanley.co.uk 0207 149 6696

The value of investments can fall as well as rise. Investors may get back less than invested. Past performance is not a reliable guide to future returns. The information in this article is for general information purposes and is not a trading recommendation. Charles Stanley is not a tax adviser.

Nothing in this article should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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