How to maximise your ISAs and SIPPs to reach financial independence

Let’s explore how you can combine your UK tax shelters to reach financial independence (FI) as quickly as possible and as safely as you deem necessary. I’ll explain my thinking as we go, so you can decide if my safe is safe enough for you.

First we need to re-state the problem with the standard FI approach.

Legend has it that you are financially independent once you’ve saved 25 times your annual expenses.

Say your annual expenses equal £25,000:

£25,000 x 25 = £625,000 = living the dream!

Except no. That’s not realistic – and I’m not even slagging off the notorious 4% rule.

It’s not realistic because most of us will have our wealth locked up in ISAs and pensions.

And this inconvenient truth changes the game.

Got 99 problems and a 4% SWR ain’t one

Let’s say you want to retire early. Continuing our example above, we’ll assume you’ve got £300,000 in your ISA by age 40 and £325,000 in your SIPP.

You’re at the magic £625,000 mark. Theoretically you can draw an income of £25,000 at a sustainable withdrawal rate (SWR) of 4%.

But wait! You can’t access your SIPP until age 55 at best. Perhaps not until age 57, or higher still if politicians keep moving the goalposts.

That means you’ll be withdrawing £25,000 from your £300,000 ISA account for at least 15 years – an 8.3% SWR.

Such a rapid rate of withdrawal means your ISA risks running out of money too fast in more than 25% of scenarios, according to work by one of the top researchers in the field, Professor Wade Pfau.

Frankly, that’s an unacceptable failure rate.

I don’t want to entertain a one-in-four chance of having to go back to work before I can tap into my pensions.

Save the entire £625,000 into an ISA and the problem disappears. Trouble is, it’s far harder to retire early without using the powerful tax reliefs available with pensions.

Save everything into a pension and retire after the minimum pension age and the problem disappears. But many Monevator readers hope to retire earlier.

The average FIRE-ee will spread their wealth across tax shelters – and the different access times, rules, and quirks can defeat simplistic withdrawal rate tactics.

However, we can crack the code so you can maximise your tax advantages, and hit FI with a realistic plan that minimises the odds of having your dream derailed by a casual cuff of chance.

Ground rules

This is going to be a series of around six posts.

Yes, it’s going to be a bit hardcore. But by the end you’ll have a guide to the key steps, tools, research, calculations, and assumptions that’ll enable you to customise your own plan.

Financial Independence means being able to live off your investments without going back to work. Yes, you can make up shortfalls in savings by picking up work but then you’re not independent. Our plan needs to be robust enough to avoid that scenario if possible.

Of course other income streams can make all the difference if you can engineer them.

Here are my working assumptions:

Before minimum pension age, we’ll fund our retirement with ISAs and – if your pre-FI income is high enough – General Investment Accounts (GIAs), which are the non-ISA, non-SIPP broker accounts that are taxed at standard rates for capital gains, dividends, and interest.

For money you’ll access beyond minimum pension age, a personal pension wins hands down as your primary savings vehicle. Some people will hit the lifetime allowance, but that’s a nice problem to have, and nothing to be afraid of. To keep things simple, I’ll assume a SIPP is our account of choice from minimum pension age on.

I’ll use conservative SWRs as the benchmark for the sustainability of our plan. The SWR metric strikes a good balance between achievability, and relative safety. Our income will be tithed from the total return via capital sales and any income generated by our assets. (Some Monevator readers aim to increase their level of security by living off investment income only. I salute them – but it’s a higher bar, takes longer to reach, and still entails risk.)

I’ve used UK tax rates in all case studies for the sake of sanity. Scottish and Welsh income taxpayers may have to adjust slightly where relevant.

We’ll take into account low expected returns, given today’s high valuation investing environment.

We’ll adjust for the fact that much of the historic research relies on benign US investment returns.

Obviously we don’t know what tax regimes will look like in decades to come. Ditto for investment returns, life expectancies, and the price of fish. All we can do is make use of the best information we have and adapt along the way. So err on the side of caution, have a back-up plan (we’ll discuss those), and let’s not be paralysed by the unknowns.

In part two of the series, I show why personal pensions are much more tax efficient than ISAs and shouldn’t be ignored, even by early retirees.

Take it steady,

The Accumulator