OFTEN overlooked, the tax-free Individual Savings Account (ISA) remains one of the most versatile saving and investment plans available to UK investors.
In this article I aim to provide you with three different ways in which you can make use of this invaluable investment allowance.
Many of you will no doubt be aware that ISAs are permanently tax-exempt. So once you have put money into an ISA, you won’t need to pay tax on either the profits you make or the income you get as interest or dividends.
The one caveat that should be added to this is that stocks and shares ISA managers are unfortunately unable to reclaim the 10% tax credit applied to dividend payments so it can be argued that ISAs aren’t truly 100% tax free. That being said, they still remain as one of the most tax-efficient and flexible investment wrappers around.
Over a short period of time, not incurring tax doesn’t make a lot of difference to the net return you get, but over a period of years the effect mounts up. Making use of your ISA allowance will ensure that your investment benefits from the full return and isn’t diminished by the ongoing effect of taxation.
What can be put in an ISA?
Whether for cash or shares, an ISA should often be the first consideration for your savings. The way it works will depend on the type of savings you put in.
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Cash ISAs
If you use a standard instant access savings account, then basic rate taxpayers have to give 20% of the interest earned straight to the Government. For higher-rate taxpayers, this leaps to 40%, and for “additional rate” taxpayers it’s now 45%.
Cash ISAs are simply savings accounts where the interest isn’t taxed, meaning it’s incredibly rare for a normal savings account to pay more interest.
For example, for a cash ISA paying 3% AER to be beaten, a basic-rate taxpayer would need a savings account offering 3.75%, while anyone paying higher rate tax would need 5% – and, at this moment in time, these sort of accounts currently aren’t out there.
Just like normal savings accounts, there’s a variety of cash ISAs available, such as instant access, fixed rate, and accounts with base rate guarantees. Details of these sorts of accounts can be sourced online or via your financial adviser.
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Stocks and shares ISAs
Share-based investments in various forms are normally ISA-able. Shares in individual companies may be placed inside what’s called a shares-based ISA, which are usually managed by stockbrokers.
It’s more usual, however, for stocks and shares ISAs to be held in collective investment vehicles like unit or investment trusts. These are pooled investments where a fund manager picks a selection of shares based on geographic or sector criteria and the value of the investment depends on the collective performance of the shares picked.
Placing investments inside an ISA wrapper provides three tax advantages. First, any profits made from share price increases aren’t eligible for capital gains tax; second, it enables all the tax on bonds to be reclaimed; and third, it means dividend income is taxed at just 10% – a significant saving for higher and additional rate taxpayers.
How much can be invested?
ISAs have become far less complex over the years. Each tax year, everyone aged 16 and over for cash ISAs (18 and over for stocks and shares ISAs), has an ISA allowance which sets the maximum that can be saved within the tax-free wrapper from April to April.
The current limit is £11,520, up to £5,760 of which can be in the form of cash. The whole chunk could be used for the stocks and shares ISA element if you wish. Based on these amounts I have listed three basic scenarios below:
- Use the maximum cash allowance: you can put £5,760 into a cash ISA, leaving £5,760 available to fill with stocks or shares (though you obviously don’t have to use this).
- Use it all for stocks and shares: you are allowed to invest in £11,520 worth of shares if you wish. However, this leaves no room for tax-free cash savings.
- Mix ‘n’ match. Any amount under £5,760 can be saved in cash, then the rest of your £11,520 allowance put in a shares ISA. For example, someone saving £2,000 in a cash ISA still has £9,520 left to invest in shares.
Any savings or investments must be made by 5th April 2014, the end of the current tax year. Crucially, unused allowances (or portions of them) don’t roll over; they are lost for good.
This means an ISA should often be the first place any savings go, as after the tax year ends, any savings or investments stay within the tax-free ISA wrapper for the future, where they’ll continue to earn interest.
These annual allowances mean it’s highly possible to have substantial amounts invested within ISA wrappers: £7,000 per year from 1999 to 2008, £7,200 per year until 2010, £10,200 for 2010/11, £10,680 in 2011/12, £11,280 for 2012/13, £11,520 for 2013/14, then rising by inflation each year after that, plus the gains (interest or investment returns) made in each year.
One important point to note is that you will also be able to transfer money saved in previous years’ cash ISA holdings to stocks and shares ISAs without affecting your current year’s allowance. It should be noted, however, that it will not be possible to transfer in the opposite direction, i.e. stocks and shares ISA to a cash ISA.
Three great ways to make use of your ISA allowance
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Save up for a house deposit
If you need to accumulate cash towards the deposit for a house, then I would recommend you put as much as you can into ISAs. The tax-efficiency of this method will ensure you will get to move in quicker. Assuming a couple both set up ISAs and both put in the maximum £5,760 into a cash ISA each year, in four years you’ll have saved £46,080. Assuming a cash ISA interest rate of 3%, this sum will have grown to around £48,000.
If you want to lock in a definite return, use a fixed rate ISA since there are currently plenty paying over 3%. I would also recommend using cash ISAs or very low-risk investment funds for this purpose in order to prevent investment volatility having a detrimental effect on your short-term savings objectives.
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University and school fees
Over the first 21 years of their lives, children can devour huge sums of cash. At the least, you’re likely to have to support them through university, but there could be education fees before that too.
So start a regular savings plan with an ISA and build up capital you can use to help pay the fees. There are no restrictions on withdrawals, so you can draw out as much as you like – from capital or as income – without incurring any tax.
Junior ISAs are also now available for those who wish to put savings away in their children’s name. Junior ISAs benefit from the same tax-efficient treatment as regular “adult” ISAs although the maximum that can be saved into one of these each year is £3,720 per tax year.
Another consideration is that the child will have the ability to access these funds at the age of 18 and will have a legal right to spend the money as desired. Perhaps on a hot hatch sports car rather than on university tuition fees! However, whether or not you tell said child about the money you are saving for his or her future is another issue entirely.
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Retirement income
Most people will need to supplement their pension income with additional income from savings. It could be argued that the ideal place to draw retirement income from is an ISA, because the income will be tax-free. So use an ISA to save regularly over the years up to retirement and then draw a tax-free income.
I believe the ideal way in which to save for one’s retirement is through a combination of pension and ISA contributions. The use of these two highly tax-efficient wrappers will give you the best of both worlds: tax relief on pension contributions and ease of access and flexibility on your ISA monies.
In summary I believe Individual Savings Accounts should be the cornerstone of many financial planning arrangements. All UK individuals are able to make use of their full allowance each year and should be encouraged to do so.
As can be seen above, the ability to shield investment returns and interest payments from taxation can have a significant benefit over time and ensure your money is made to work as hard as possible without being adversely affected by taxation.
