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Tax benefits of ISAs explained

Understanding the tax benefits of your ISA account can help you to make the right decisions as you explore the options for growing your money

Topic: Investing, ISA

The most important aspect of any ISA (individual savings account) is the tax benefits. ISAs were introduced in 1999 to encourage people to put money aside for the medium- to long-term, primarily in the form of cash savings or stock market investments.

The key incentive for opening an ISA is that you won’t have to pay income tax on interest earned by saved cash, and also that no income tax or capital gains tax will be liable on investments held in an ISA.

In each tax year, you can save up to a maximum amount within the ISA tax-free wrapper, and whatever part of that allowance you have not used that year will be lost forever. The ISA tax year runs from April 6 to April 5, and you can invest up to £20,000 (2018/2019) in a stocks and shares ISA or cash ISA in each tax year.

How tax on savings and investments works

Interest earned in a non-ISA savings account is normally subject to income tax. Investors also have to pay income tax on any interest received from corporate or government bonds, or on dividends paid by companies to their shareholders. Interest is taxed at the basic rate of 20% or at the higher (40%) or additional rate (45%), depending on your total taxable income in a given financial year.

With investments such as shares or funds held outside an ISA, any gains – that is, the difference between the cost of the investment and its value when it is sold – are subject to capital gains tax. This is currently levied at 10% for basic-rate taxpayers and 20% for higher-rate taxpayers.

The tax advantages of ISAs may change in the future and also depend on your individual circumstances.

Tax allowances this tax year (2018/2019)

For both cash and investments, however, the rates outlined above do not tell the whole story. For example, every individual in the UK receives a tax-free personal income tax allowance – currently £11,850 a year, rising to £12,500 in 2019/2020 – which means any income below that allowance threshold, including interest on savings, is tax-free.

Additionally, a new personal savings allowance was introduced in 2016: this is the sum of money that can be earned in interest every tax year before income tax is due. At present, the allowance stands at £1,000 a year for basic-rate taxpayers and £500 for those on the higher rate. Anyone paying additional rate income tax does not qualify for the personal savings allowance.

At the same time, investors are entitled to a certain level of tax-free capital gains on their investments each year. The capital gains tax allowance in the 2018/2019 financial year is £11,700; this will rise to £12,000 in 2019/2020.

And there’s a dividends allowance of £2,000 in the current tax year. So you can receive dividend payments up to this amount without paying tax, even outside of an ISA. But any dividend payments received over £2,000 will be subject to tax, depending on the income tax band you’re in: 7.5% if you’re a basic rate tax payer, 32.5% if you’re a higher rate tax payer, or 38.1% if you’re an additional rate tax payer.

So the tax benefits of ISAs really become important when you have a large amount invested, usually if you’ve been contributing to your ISA over a number of years.

Long-term tax benefits of ISAs

For anyone investing for the first time in an ISA, it might not be immediately clear whether their account’s tax-free status is particularly valuable, given that there is a limit of £20,000 (2018/2019) that can be saved or invested in the ISA tax year.

But it is worth bearing in mind that the tax breaks don’t just apply in the year your ISA is set up; the interest and investment gains they generate remain free of tax, regardless of how much extra money is added to the account in the years ahead.

In the current low-interest-rate environment, returns on cash ISAs are especially low. But even with an account paying 2% a year, someone who managed to use their full annual allowance each year could be earning over £2,000 a year in interest after five years – and would typically therefore avoid at least £200 a year in income tax through the ISA by that point.

Stocks and shares ISAs and capital gains tax

Stocks and shares ISAs, such as the Click & Invest Stocks and shares ISA, offer a tax-efficient way to invest in financial markets. All profit you earn through investments is protected from tax as long as it remains in the ISA tax wrapper, and so there will be no tax to pay on this money when you withdraw it from your account This means you won’t have to pay capital gains tax, or income tax on any dividends a company may pay out to its shareholders. Your investment is also exempt from income tax on any interest you earn from corporate or government bonds.

In recent years, typical returns on investment funds have generally been a good deal higher than on cash. And while there are no guarantees of future investment performance, this could mean that the potential tax benefits available to holders of stocks and shares ISAs in years to come are very sizeable indeed.

Take an investor who started with a £20,000 lump sum, and then invested the same amount every year – ideally, in monthly instalments to help smooth out the risks associated with investing.

For example, at a return of 5% a year after charges and inflation, this would lead to a capital gain of nearly £20,000 after five years – well above the current personal capital gains tax allowance. If the investment was increased at the same rate over 10 years, and at the same level of return, this gain would rise to almost £70,000.

For a higher-rate taxpayer, realising such a gain during the 2018-19 financial year would lead to a capital gains tax bill (after deducting the capital gains tax allowance) of more than £11,500 – but this would not be the case if the investment was held within an ISA.

Looking to invest in a stocks and shares ISA? Read our guide on what to expect if you’re investing in a stocks and share ISA to learn more.

ISAs and tax: Key facts

  • The money you hold in an ISA – whether in cash savings or investments such as shares and bonds – is protected from income and capital gains tax as long as it remains in the ISA. There will be no tax to pay on this money when you withdraw it from your account.
  • Higher-rate and additional-rate taxpayers stand to gain most from the tax-free status of stocks and shares ISAs. For example, the current capital gains tax rate for higher-rate income taxpayers is 20%, as opposed to 10% for those on the basic rate.
  • Your ISA allowance for 2018/19 and 2019/20 is £20,000. You cannot carry this allowance forward, so if you don’t use it before the tax year ends on April 5 you lose it.
  • You can put money into different types of ISA, like a cash ISA and a stocks and shares ISA, even during the same tax year. However it important that you do not exceed the annual limit, which currently stands at £20,000.
  • Transferring ISAs from previous years will not count towards your ISA allowance for this year . You don’t have to stick to the same type of ISA, either. You can transfer from a cash ISA to a stocks and shares ISA (and vice versa) – read our guide to transferring ISAs to find out more.

With investment your capital is at risk. The tax advantages of ISAs may change in the future and also depend on your individual circumstances.

This article is not intended to constitute personal advice and no action should be taken, or not taken, on account of information provided. Opinions given within this article are the speakers’ own personal views. The views and opinions are effective from the date of publication but may be subject to change without notice.

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