Most types of savings and investment can mean that the taxman may take a share of the interest or other returns you earn. This means that the returns you enjoy are smaller, and your money grows more slowly. Individual Savings Accounts or ISAs can help your money can grow faster, because they mean that the money you put in them is protected from tax. But does that mean that you should choose an ISA rather than some other kind of saving or investment plan?
Most of us don’t think too much about tax. We simply pay it when it is deducted from our wages. But if you are looking at growing your money, you need to understand how tax affects your savings or investments. Almost any income you earn, through wages, interest or dividends, is subject to income tax.
Banks or building societies used to automatically take off 20% basic-rate tax from any savings interest. Today, most people have a savings allowance, which means basic taxpayers can get £1,000 interest each year without being taxed – while higher-rate taxpayers have £500. This means ordinary savings accounts are paid without deducting tax, which has made them much more rewarding.
The government estimates that 95% of savers no longer pay tax on their savings. This might seem to make ISAs much less attractive, especially when ordinary savings accounts or high-interest current accounts can beat the returns offered by ISAs. But remember, all of the money you earn in an ISA is completely tax-free and should stay that way. £1000 tax-free interest may sound a lot, but if you maximise your allowance each year, you can accumulate large sums in your ISA. Interest rates will probably not stay low, and after a few years you would probably start to exceed your allowance.
If interest rates went back to their historic average of around 4%, after just five years of contributing the maximum to your ISA, you would have £100,000 saved (not counting growth) and expect to earn interest of £4,000 on it. Thanks to your ISA, you would have no tax to pay. With the same money in a saving account, as a higher rate taxpayer you might escape tax on the first £500, but then you would find yourself paying 40% tax on the remaining £3500 interest which your money had earned, cutting it down to just £2100. Of course, this is still theoretical, as most savings plans, and most Cash ISAs are still struggling to reach 4% interest rates. But other types of ISA can offer more attractive returns.
Cash ISAs are savings plans, and current low rates mean they will take several years to attract the attention of the taxman. But other types of ISA – such as Stock and Shares ISAs and Innovative Finance or IF ISAs can be much more rewarding. They do not offer fixed rates – but they can provide the potential to deliver returns substantially higher than you can expect from Cash ISAs.
As ISAs they mean no income tax or capital gains tax to eat away at your returns. The simple fact is that putting your money inside an ISA can be much more effective at growing it than having the very same saving or investment outside ISA protection.
How much could I save with an ISA?
Because of the advantages of tax-free savings and investment, it clearly makes sense to put as much as you can inside the protection of your ISA. However, tax-free savings and investments are so attractive that the government has a limit on the funds you can put into your ISA account each tax year.
This known as the ISA allowance. It is the same for everyone, and for the current, 2019/20 ISA tax year it is £20,000, for anyone aged over 18. This means that you can invest up to £20,000 in ISAs before midnight of April 5th, 2020. The limits are strict, and you cannot carry forward part of your ISA allowance from one year to the next. If don’t use all of your ISA allowance before the end of the tax year you will have lost it - although you will have a new £20,000 allowance for the new tax year starting on April 6th.
You can put your ISA allowance into a Cash ISA, or all into a Stocks and Shares ISA, or all into an IF ISA. Many people like to diversify their investments, and you can set up more than one type of ISA at the same time and spread investment between them. The ISA Allowance does not change, and if you do have two or more different ISAs, your maximum contribution in any given year will still be £20,000. Whatever you decide, you need to look at what kind of ISA offers the level of returns you want.
Remember, although the amount you can put in for one year is limited by the allowance, there is no limit on the amount you can build up in your ISA accounts. So, by making the most of your allowance, and by choosing an ISA that can offer good prospects for growth, you should be able to build up a sizable nest egg in your ISA over the course of a few years.
Do I have to make a lump sum investment?
Not everyone has £20,000 as a lump sum to invest, but you can still start building up your ISA holdings if you choose an ISA that allows monthly deposits. The maximum you can invest in the course of year is still fixed at £20,000, but even if you only put in few hundred pounds each month, you have the satisfaction of knowing that your money can grow steadily without tax.
You can invest the full £20,000 ISA Allowance into an Innovative Finance ISA, but with RateSetter, you have the choice of spreading your ISA investment across the whole tax year when you have cash available.
Please note that tax treatment depends on individual circumstances and may be subject to change in the future. Capital at risk. No FSCS protection.