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Potential tax savings from investing in ISAs

Tax may not be the primary concern of casual investors but may turn out to be costly; so tax efficient investments are always worth considering. An ISA is an appealing option commonly utilised by investors, so it is worth understanding their benefits

What is an ISA?

An Individual Savings Account (ISA) is a fund to which an individual contributes towards at their discretion and which is then invested on their behalf or generates interest. Specifically, it can contain stocks and shares, cash or a combination of both. All interest, dividends and capital gains on the cash or assets held within the account are tax free. Every tax year, which runs from 6 April to 5 April, individuals can save up to an annual allowance, £20,000 in 2020/21, in a single ISA, or spread it across multiple accounts.

Advantages

Choosing to invest outside of an ISA could cost be very costly, particularly for long term savers. The table below shows the rate at which income and capital gains are taxed above an individual’s allowances highlighting potential savings that an ISA can provide.

Tax Rates 2020/21

 

Interest

Dividends

Capital Gains

Allowances/Exemptions

£1,000 BR/ £500 HR

£2,000

£12,300

Basic Rate (BR)

20%

7.5%

10%/ 20%

Higher Rate (HR)

40%

32.5%

20%

Additional Rate

45%

38.1%

20%

 

Sustained investment in an ISA can see capital accumulate, the more so with the reinvestment of the tax free dividends and interest. Although interest rates are at a historical low and the market is particularly volatile, long term investments remain practical. Investing small amounts on a regular basis, possibly through a direct debit, into a volatile market may result in the average cost over time being less than that on a lump sum investment. It also removes the decision about when is the right time to invest.

ISAs are very much geared towards long term investment and can help facilitate substantial long term growth. There are more ISA options available than the standard stocks and shares ISA, some of which like the now unavailable (but still running) Help to Buy ISA and Lifetime ISA, practically compel long term investment.

Can you move an existing portfolio into an ISA?

Stocks and shares ISAs only allow the introduction of cash, not existing holdings of shares, but there is the alternative known as bed and ISA, which entails the disposal of a portfolio before transferring the cash into the ISA and then using the cash to repurchase the shares. This will most likely realise a capital gain, but given the annual allowance for ISAs is only £20,000 it is unlikely this gain will far exceed an individual’s annual exemption of £12,000. If an individual routinely realises significant capital gains in their personal capacity, the tax can be considerable, but there is scope to coordinate the realisation of gains with utilisation of the annual exemption.

Taxation of ISAs on death

There is a common misconception that ISAs are completely tax free. While gains and income produced within the ISA are not subject to tax, the value of an ISA still forms part of a deceased individual’s estate and is potentially subject to inheritance tax at 40%. An individual can mitigate this cost by transferring their ISA to their spouse or civil partner on death, which is covered by the IHT inter-spouse exemption. 

The surviving spouse then has a choice.  The first option is to transfer the ISA into their own name, which must be done within 180 days of the beneficial interest being transferred by the executors. Alternatively, they can elect to take an additional ISA allowance equivalent to the value of the deceased partner's ISA when they died, even if those ISA funds are bequeathed to someone else in the will.  This election has to take place within 180 days of the administration of their spouse’s estate being completed or by the end of three years after their death, whichever later. 

ISAs retains their tax-free status for up to three years from the date of death, so income and gains realised in the administration period of the estate will be exempt for the Executors.

Lifetime ISA

The Lifetime ISA is used for saving later in life or the purchase of a first home. Individuals must be between the ages of 18 and 40 to open one, while the maximum contributions one can make per year is £4,000 until the age of 50, after which one can no longer pay in. The government will add a 25% bonus to contributions up to a maximum of £1,000 per year.

The Lifetime ISA is flexible in terms of the mixture of cash, stocks and shares it can contain.  

There are three circumstances in which money can be withdrawn from a lifetime ISA, namely if the investor is:

  • aged over 60;
  • buying their first home;
  • terminally ill, with less than 12 months to live

In any other case, a 20% charge will be due when withdrawing funds in order to recover the government bonus (rising to 25% from 6 April 2021). This makes the Lifetime ISA an ineffective way to save short term.

Junior ISA

Children are eligible if they are under 18 and living in the UK, although there are exceptions for children of Crown servants living outside the UK. Parents or guardians with parental responsibility can open a Junior ISA (JISA) and manage the account, but the money belongs to the child who then can take control of the account when they reach 16, but cannot withdraw the money until they turn 18.

JISAs come in two types:

  • a cash JISA;
  • a stocks and shares JISA.

Individuals can have one or both types

While anyone can pay into the JISA, contributions are limited to £9,000 in 2020/21. The £9,000 can be split between two ISAs. Once paid in, money can be transferred between JISAs and a Child Trust Fund account freely, but not into an adult ISA. JISAs automatically turn into an adult ISA when the child turns 18 and remain exempt from tax.

Gifts to children ordinarily cause complications because of the parental settlement rule. If the gift generates gross income above £100, be it interest or dividends, all of the income is taxed on the parent who made the gift. Gifting into a JISA circumvents this risk, meaning parents do not suffer a tax liability from income generated by assets in their children’s name.

More on JISAs can be found here. 

Conclusion

While an ISA will not necessarily save everyone large sums of tax, e.g. those who have interest, dividends and capital gains all less than the respective allowances, additional rate taxpayers can potentially save tax of up to 45%. Those who don’t receive significant dividends or interest may be attracted to the Lifetime ISA which provides a government supplement, while JISAs are a low maintenance and effective way to secure your children’s financial future without, as a parent, paying tax on their income. For everyone though it provides a good opportunity to put away cash and accumulate assets for the long term.

About the author

Akin Coker

+44 (0)20 7556 1332
cokera@buzzacott.co.uk

What is an ISA?

An Individual Savings Account (ISA) is a fund to which an individual contributes towards at their discretion and which is then invested on their behalf or generates interest. Specifically, it can contain stocks and shares, cash or a combination of both. All interest, dividends and capital gains on the cash or assets held within the account are tax free. Every tax year, which runs from 6 April to 5 April, individuals can save up to an annual allowance, £20,000 in 2020/21, in a single ISA, or spread it across multiple accounts.

Advantages

Choosing to invest outside of an ISA could cost be very costly, particularly for long term savers. The table below shows the rate at which income and capital gains are taxed above an individual’s allowances highlighting potential savings that an ISA can provide.

Tax Rates 2020/21

 

Interest

Dividends

Capital Gains

Allowances/Exemptions

£1,000 BR/ £500 HR

£2,000

£12,300

Basic Rate (BR)

20%

7.5%

10%/ 20%

Higher Rate (HR)

40%

32.5%

20%

Additional Rate

45%

38.1%

20%

 

Sustained investment in an ISA can see capital accumulate, the more so with the reinvestment of the tax free dividends and interest. Although interest rates are at a historical low and the market is particularly volatile, long term investments remain practical. Investing small amounts on a regular basis, possibly through a direct debit, into a volatile market may result in the average cost over time being less than that on a lump sum investment. It also removes the decision about when is the right time to invest.

ISAs are very much geared towards long term investment and can help facilitate substantial long term growth. There are more ISA options available than the standard stocks and shares ISA, some of which like the now unavailable (but still running) Help to Buy ISA and Lifetime ISA, practically compel long term investment.

Can you move an existing portfolio into an ISA?

Stocks and shares ISAs only allow the introduction of cash, not existing holdings of shares, but there is the alternative known as bed and ISA, which entails the disposal of a portfolio before transferring the cash into the ISA and then using the cash to repurchase the shares. This will most likely realise a capital gain, but given the annual allowance for ISAs is only £20,000 it is unlikely this gain will far exceed an individual’s annual exemption of £12,000. If an individual routinely realises significant capital gains in their personal capacity, the tax can be considerable, but there is scope to coordinate the realisation of gains with utilisation of the annual exemption.

Taxation of ISAs on death

There is a common misconception that ISAs are completely tax free. While gains and income produced within the ISA are not subject to tax, the value of an ISA still forms part of a deceased individual’s estate and is potentially subject to inheritance tax at 40%. An individual can mitigate this cost by transferring their ISA to their spouse or civil partner on death, which is covered by the IHT inter-spouse exemption. 

The surviving spouse then has a choice.  The first option is to transfer the ISA into their own name, which must be done within 180 days of the beneficial interest being transferred by the executors. Alternatively, they can elect to take an additional ISA allowance equivalent to the value of the deceased partner's ISA when they died, even if those ISA funds are bequeathed to someone else in the will.  This election has to take place within 180 days of the administration of their spouse’s estate being completed or by the end of three years after their death, whichever later. 

ISAs retains their tax-free status for up to three years from the date of death, so income and gains realised in the administration period of the estate will be exempt for the Executors.

Lifetime ISA

The Lifetime ISA is used for saving later in life or the purchase of a first home. Individuals must be between the ages of 18 and 40 to open one, while the maximum contributions one can make per year is £4,000 until the age of 50, after which one can no longer pay in. The government will add a 25% bonus to contributions up to a maximum of £1,000 per year.

The Lifetime ISA is flexible in terms of the mixture of cash, stocks and shares it can contain.  

There are three circumstances in which money can be withdrawn from a lifetime ISA, namely if the investor is:

  • aged over 60;
  • buying their first home;
  • terminally ill, with less than 12 months to live

In any other case, a 20% charge will be due when withdrawing funds in order to recover the government bonus (rising to 25% from 6 April 2021). This makes the Lifetime ISA an ineffective way to save short term.

Junior ISA

Children are eligible if they are under 18 and living in the UK, although there are exceptions for children of Crown servants living outside the UK. Parents or guardians with parental responsibility can open a Junior ISA (JISA) and manage the account, but the money belongs to the child who then can take control of the account when they reach 16, but cannot withdraw the money until they turn 18.

JISAs come in two types:

  • a cash JISA;
  • a stocks and shares JISA.

Individuals can have one or both types

While anyone can pay into the JISA, contributions are limited to £9,000 in 2020/21. The £9,000 can be split between two ISAs. Once paid in, money can be transferred between JISAs and a Child Trust Fund account freely, but not into an adult ISA. JISAs automatically turn into an adult ISA when the child turns 18 and remain exempt from tax.

Gifts to children ordinarily cause complications because of the parental settlement rule. If the gift generates gross income above £100, be it interest or dividends, all of the income is taxed on the parent who made the gift. Gifting into a JISA circumvents this risk, meaning parents do not suffer a tax liability from income generated by assets in their children’s name.

More on JISAs can be found here. 

Conclusion

While an ISA will not necessarily save everyone large sums of tax, e.g. those who have interest, dividends and capital gains all less than the respective allowances, additional rate taxpayers can potentially save tax of up to 45%. Those who don’t receive significant dividends or interest may be attracted to the Lifetime ISA which provides a government supplement, while JISAs are a low maintenance and effective way to secure your children’s financial future without, as a parent, paying tax on their income. For everyone though it provides a good opportunity to put away cash and accumulate assets for the long term.

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This article highlights the potential tax savings from investing in ISAs. However, we would recommend that you to take professional advice before making such investments. If you would like to speak to one of our financial planning specialists, please fill out the form below and we will be in touch shortly.

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