To stand a chance of making a million on the market, it’s a no brainer that you should be holding your investments within a tax-efficient wrapper such as a Stocks and Shares Individual Savings Account (ISA) and a Self-Invested Personal Pension (SIPP).
Both save you from paying any capital gains tax on the profits you make or any income tax on dividends you receive. But does it makes sense to say that one might get you to millionaire status first? In theory, yes.
Make me a millionaire!
Let’s say you start with nothing but can put £400 a month into an ISA that gives an average 7% annual return over 40 years. That will give you a little over £1.03m at the end, according to my calculations.
If you use a SIPP, that £400 will generate an extra £100 in tax relief (if you’re a basic rate taxpayer), essentially bringing your monthly contribution to £500. Here, you’ll have £1.04m rounded up, assuming a 7% annual return but, importantly, after only 38 years.
This example illustrates the power of compounding on two fronts. Firstly, both scenarios show just how powerful the stock market can be as a wealth-generating mechanism compared to something like a standard bank account. The latter may feel more comfortable but, to use an old adage, you must “speculate to accumulate.“
Secondly, that extra £100 of tax relief per month can knock years off the time it takes to hit a million. That may not seem like much compared to the several decades required to build your wealth, but I’d say it’s worth it.
Am I oversimplifying things? Absolutely. Your actual annual returns will depend on your asset allocation (i.e. how much money you put in shares, bonds, gold etc), the behaviour of markets, and whether your monthly contributions change for better or worse.
On the last point, it’s worth highlighting that you can currently invest up to £20,000 in an ISA per year. A SIPP, on the other hand, allows you to invest up to 100% of your gross annual income up to £40,000. Clearly, the more you can save, the better.
There are a couple of other complications. I’ve not taken anything off for the payment of fees, which can be slightly higher for SIPPs.
Worth remembering too, is the fact that tax rules can change and the total amount you can save into pensions over your lifetime without triggering extra charges is currently capped at £1.055m.
So SIPP or ISA?
So should you opt for a SIPP? Not necessarily. As with all investment decisions, your account of choice will depend on your financial goals and just how long you intend to keep your money in the market.
While a SIPP may allow you to reach a million quicker, thanks to more money being compounded, you will eventually be taxed on any withdrawals you make beyond the 25% tax-free lump sum you can receive when you’re 55.
By contrast, you won’t be taxed on withdrawals from an ISA. These can also be made whenever you like, although be aware you may get back less than you invest.
A solution may be to have both types of account, thereby giving you a degree of flexibility while also having the opportunity to shelter up to £60,000 from the taxman and, conceivably, reach the magic million even quicker.
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Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.