Originally published at: A comprehensive guide to taxes and fees on pensions – InvestEngine Insights
A SIPP, or a Self-Invested Personal Pension, is a pension scheme that allows you to save, invest and build up a pot of money for when you retire. Unlike traditional pension plans, SIPPs offer individuals a much broader range of investment options and greater control over their retirement savings.
The key feature of a SIPP is that it offers a level of autonomy and flexibility that traditional pension plans do not. This means that you can tailor their investments to align with your risk tolerance, financial goals, and investment preferences.
You control how much you save and how often. You could choose to make regular contributions or pay in lump sums as and when you choose.
A major benefit of SIPPs is that contributions qualify for tax relief. This means that your contributions are boosted by a payment from the government.
For basic-rate taxpayers, contributions you make receive basic-rate income tax relief.
For example, if you contribute a lump sum of £8,000 into your SIPP, you’ll get tax relief of £2,000 from the government, so a total of £10,000 is added to your SIPP.
If you’re a higher-rate (40%) taxpayer, you can also claim extra tax relief of up to £2,000 through your self-assessment tax return, and up to £2,500 if you’re an additional-rate (45%) taxpayer.
This means you receive a guaranteed ‘return’ on any money you contribute to your SIPP. If you’re a basic-rate taxpayer, your contributions effectively receive a guaranteed 25% increase from the government top-up. If you’re a higher-rate taxpayer, your contributions receive a guaranteed 67% return from the combination of the government top-up plus the reclaimed tax. For additional-rate taxpayers, it’s 82%:
It’s important to remember that the government isn’t giving away all this cash for free. The main considerations are:
- You can’t access your SIPP until the age of 55 (rising to 57 in 2028),
- For most people, only up to £60,000 a year can currently be saved into a pension. If you’re a high earner with an income above £200,000 a year, your annual allowance might gradually reduce to £10,000. This is known as the ‘tapered annual allowance’,
- While you receive tax relief when making your contributions, you may have to pay some tax when withdrawing the cash in retirement. When you decide to start drawing down your pension, 25% of any lump-sum withdrawal is tax free, but any the rest is treated as regular taxable income. Most investors still see this as favourable though, as you’ll likely be paying a lower rate of tax in retirement compared to when you made your SIPP contributions.
While these restrictions must be borne in mind when contributing to your SIPP, the flexibility and tax benefits are extremely powerful when saving for retirement, and can significantly increase the value of your pension pot.
SIPP fees
Fees are another important consideration when investing into a SIPP.
There are several types of fees which may be charged on SIPPs. These could include:
- Platform fee/annual administration charges (some providers combine the platform and administration charges)
- Dealing fees
- Ongoing charges for the underlying investments
- Dividend reinvestment fees
- Drawdown charges
- Set-up fees
- Transfer out fees
Over time, these fees can have a significant impact on your SIPP’s value.
The chart below shows the impact of fees on a portfolio over 40 years, assuming total contributions (before government top-up or any reclaimed tax relief) of £400 per month and 7% gross returns:
This portfolio would grow to over £1.5m with no fees, £1.2m with a 1% annual fee, and £940k with a 2% annual fee. The difference between the portfolio with no fees and the one with a 2% fee is over £600,000 – almost halving the portfolio’s final value.
The bottom line is that fees matter, and can have a huge impact on the size of a portfolio over time.
In percentage terms, a 1% annual fee reduces the final value of a portfolio by 24%, and a 2% fee reduces it by 41%. This remains true no matter what the contribution levels are:
Bringing it all together, the chart below shows how an investment pot would grow over 40 years, assuming an investor paid £400 per month into their pension (before any government top-ups or reclaimed tax) and was a higher-rate taxpayer:
£400 per month in contributions equates to £4,800 per year, or £192,000 over 40 years. The government adds £2,400 per year – £1,200 as a basic-rate top up, and £1,200 which has to be reclaimed. This reclaimed amount can then be reinvested, for further tax relief. This adds up to £120,000 over 40 years. The bulk of the SIPP’s growth over the total period, though, comes from the investment growth, which we assume is 7% per year before fees, adding over £1m to the portfolio size, and bringing the pot to almost £1.6m.
Fees, however, drag the portfolio down, reducing the final value by over £350,000, and bringing the total portfolio size after 40 years to £1.2m. The less the investor pays in fees, the smaller the pink rectangle, and the closer the total portfolio size gets to the maximum fee-free scenario of £1.6m.
Worth noting is that of the no-fee potential portfolio value of £1.6m, only £192k has come from the investor – they only contributed 12% of the portfolio’s final value. 8% came from the government’s tax relief, and the remaining 80% came from investment growth.
This illustrates just how powerful a low-cost SIPP can be for long-term wealth creation. The investor saved just £400 per month, and ended up with a portfolio well over £1m. While it’s unrealistic to expect an investor to pay no fees at all, even a 1% annual fee would result in the investor becoming a millionaire after 40 years.
Reclaiming tax
Ensuring all tax benefits are fully utilised is also crucially important for maximising the size of your pension.
While the figures above may make the government contributions appear less important in the overall value of a portfolio over 40 years (only 8% of the final portfolio value), it’s the combination of the member’s contributions and the government tax top-ups which the compound interest from the market applies to. Without them, the market’s growth would have nothing to work on. They are the foundation of the portfolio, and without them greatly reduce a portfolio’s growth potential.
The chart below shows the impact of fees and the impact of both the automatic government top-up and the amount of tax reclaimed from HMRC. The chart assumes member contributions of £400 per month for a higher-rate taxpayer and growth of 7%.
Not reclaiming the higher-rate tax relief from HMRC – an extra £100 per month, which is reinvestable – reduces the final portfolio value by £350k, to £1.2m. Investing without either of the government tax benefits (basic-rate top-up or reclaimed tax) results in an over £600k lower portfolio value, worth under £1m. This shows how powerful the tax benefits of a SIPP are compared to investing in a taxable account.
However, paying nothing in fees is unrealistic, and including a 1% fee reduces the eventual pension size even further. Not reclaiming the higher-rate tax from HMRC plus also paying a 1% fee reduces the potential pension pot from £1.6m to under £1m, meaning over £600k is lost.
This shows both the importance of reclaiming the higher-rate tax from HMRC and the importance of minimising fees. Doing both of these on a consistent basis results in a significantly higher pension size over 40 years – on the flip side, paying too much in fees and not reclaiming the additional tax results in a dramatically lower pension pot.
How to reclaim higher/additional rate tax
There are 2 ways you can claim rate tax relief on pension contributions if you’re a higher or additional-rate taxpayer:
- Via your online Self Assessment tax return
- By contacting HMRC directly
The easiest way to claim is through an online tax return. You’ll need to look for the “tax reliefs” section and add your pension contributions. (NB: It’s important that you add the total gross pension contributions for the relevant tax year. This includes the basic 20% tax relief you’ve already received.)
You can also claim higher rate tax relief on your pension contributions by contacting the HMRC tax office. You can contact them over the phone, but may also be asked to confirm your pension details in writing (by writing to them – they don’t accept email communication). Bear in mind that you’ll need to submit a new letter every time you alter your pension contributions or your salary changes.
Retiring early
Because fees (and the potential for not claiming back all possible tax relief) are such a significant drag on returns, this affects not only an individual’s final pension pot size, but also how early they could retire.
According to figures from the Pension and Lifetime Savings Association (PLSA), a single person who owns their own home will need an income of £43,100 per year for a comfortable retirement. Assuming a state pension of £11,502 per year, this leaves a gap of £31,598 per year to be filled by a personal pension.
If we also assume 4% of the portfolio can be withdrawn safely each year (while debateable, 4% is a good benchmark), this equates to a required portfolio size of £789,940. Rounding that figure to £800k for simplicity, this is how long it would take to reach a portfolio size of £800k at differing levels of monthly portfolio contributions and fee levels (assuming 7% returns a year):
Reducing fees can have a huge impact on how early you can retire – someone investing £300 a month (before government top-up or any reclaimed or reinvested tax) and paying no fees could retire 8 years earlier than someone paying 2% a year.
The impact of fees is especially pronounced for those investing smaller amounts. These investors take longer to reach their wealth goal, meaning fees have a longer time to compound, and so drag on the portfolio for longer.
Summary
Investing in a Self-Invested Personal Pension (SIPP) is a great way to take control of your retirement planning while enjoying significant tax advantages. SIPPs offer generous tax relief on contributions, boosting your savings by 67% for higher-rate taxpayers, and 82% for additional-rate taxpayers. Investors should be aware, though, that they must reach out to HMRC directly to claim the extra tax relief if they’re higher or additional rate taxpayers.
Fees can also significantly impact your portfolio over time, making it crucial to choose a low-cost provider to maximise your savings. By taking advantage of tax benefits and minimising fees, a low-cost SIPP can help you achieve a more comfortable retirement and potentially retire earlier.
Important information
- When investing, your capital is at risk.
- Tax treatment depends on personal circumstances and may be subject to change.
- InvestEngine does not offer financial advice. If in doubt, contact an Independent Financial Advisor.
- Past performance does not guarantee future performance.
- The scenarios presented are an estimate of future performance based on past data relating to variations in the value of this investment and/or current conditions; they are not an exact indicator. What you get will depend on how the market performs and how long you hold the investment or product.