How tax changes will make ISAs even more valuable to investors

Running through the different types of tax wrapper and the benefits they bring

ISAs are now in their 24th year of existence and very much part of the furniture for many savers and investors. Indeed, they can become so familiar that it’s easy to lose sight of the tax benefits that makes these accounts so attractive in the first place.

We also sit on the cusp of a raft of tax changes which mean ISAs are about to become even more valuable, as the Exchequer seeks to balance its books by increasing the tax take. With the end of tax year rolling around soon on 5 April, here’s a bit of a refresher on the basic tax reliefs available on ISAs, which will hopefully help you decide the best way to shelter your savings from the coming tax tsunami.

WHAT ARE THE BENEFITS OF A CASH ISA?

A Cash ISA allows you to receive your interest from cash tax-free. However, the personal savings allowance means that basic rate taxpayers can receive £1,000 each year tax-free anyway, and higher rate taxpayers can receive £500.

Combined with the fact that often the savings rate on ISAs is lower than that on traditional savings accounts, this has led some to question whether Cash ISAs are such a no brainer for savers. It really does depend how much tax benefit you’re getting, and how much better a rate you could get outside an ISA.

Additional rate taxpayers, for instance, get no personal savings allowance, and so are subject to 45% tax on their savings interest. There would therefore need to be a hefty gap between interest rate on Cash ISAs and savings accounts to justify additional rate taxpayers turning their nose up at the benefits of the tax shelter. More people will soon be bought into this tax band as in April the threshold will fall from £150,000 to £125,140. A basic rate taxpayer saving a small sum by contrast, may find no tax benefit in holding money in an ISA, because of the personal savings allowance, so they might as well simply go for the best rate.

Investors should also consider whether they have enough cash and might be better off investing longer term savings in the stock market. A rough rule of thumb is to keep three to six months of expenditure in cash and invest the rest in the market in search of higher long-term returns, albeit with more risk.

How Stocks And Shares Isas Help With Dividends And Capital Gains

A Stocks and Shares ISA offers investors protection from capital gains tax and income tax on dividends or interest payments made by the funds or shares they hold. These investment accounts are going to become even more vital for investors because the government is slashing the amount of gains and dividends you can receive without paying tax.

Currently you can receive £2,000 of dividends each year tax free. That is being cut to £1,000 next year and £500 the year after. Any dividends received above these allowances are taxable at rates of 8.75% for basic rate taxpayers, 33.75% for higher rate taxpayers, and 39.35% for additional rate taxpayers. Keeping dividends protected from tax is therefore becoming even more critical.

The same goes for capital gains tax. Currently there is a fairly generous £12,300 capital gains tax allowance each year. This permits you to make gains up to this amount each year without being liable to capital gains tax. This allowance is being reduced to £6,000 in April and £3,000 the April after. Gains made above this level are taxable at 10% for basic rate taxpayers and 20% for higher rate taxpayers, with an 8% surcharge on gains from property sales. Protecting your profits from capital gains tax in an ISA will not only save you money, it will also mean you don’t have to engage in capital gains tax calculations for your tax return, which can be extremely complex, to say the least.

Free Money From A Lifetime Isa But There Are Strings Attached

Alongside the Stocks and Shares ISA, there is of course now the Lifetime ISA. These accounts can be used to save for a house purchase or retirement. They can be opened by anyone over 18 but under 40, and once open you can inject up to £4,000 each tax year up until your 50th birthday. That £4,000 does count towards your £20,000 overall ISA allowance though. Like a standard ISA, dividends, interest, and gains are free from tax, but the real attraction of the Lifetime ISA is the 25% government bonus you get each time you contribute. If you put £4,000 in each year, the government will add another £1,000 to your pot.

There is of course, no such thing as a free lunch, and this act of generosity does come with some strings attached. You can take money out of a Lifetime ISA only to fund your first house purchase, or if you’re over 60. Withdrawals at any other time are subject to a 25% penalty charge, which more than offsets the bonus you receive from the government. Nonetheless if you are saving for your first house, or a basic rate taxpayer saving for retirement, a Lifetime ISA is certainly worth considering because of the generous tax reliefs attached.

Alongside pensions, ISAs are one of the basic building blocks of a tax efficient savings and investment plan, and each year the annual allowances expire on 5 April. There’s nothing like a deadline to stimulate activity, and vast legions of investors leave their contributions to the last minute, with a few running perilously close to the bell for last orders. The danger of missing the deadline is heightened this year, because the tax implications of losing out on the protection afforded by an ISA are becoming much more substantial.

By Laith Khalaf AJ Bell Head of Investment Analysis