INCOME: THE OVERLOOKED POWER OF ISAs
This article explores the astonishing value presented by ISAs. Nothing else comes close when it comes to saving tax on income and withdrawals. Despite this, most people miss out on this opportunity, even savvy investors.
- The most powerful feature of your ISAs
- How to exploit your ISAs to their maximum potential
- Get our free guide “How to make the most of your investments”
ISAs grant you an astonishing power to avoid tax on income and withdrawals. Despite this, most people miss out on this opportunity.
The most powerful feature of your ISAs
Most of us get the idea that ISAs allow for tax-free investing. We each get to shelter up to £20,000 each year from the taxman. This is all above board, completely legal and does not involve any financial trickery. The Government expects you to use this allowance.
Find out more about how the new ISAs work here.
This is a great feature of your ISAs, and over time adds up to massive investment growth. But even this is not the most powerful feature.
The feature most often overlooked and ignored is that you can withdraw your money in the form of income or capital completely tax-free. This is an astonishing benefit when you take the time to examine it. In fact, it’s so vital (and easy to implement) that you’ll be kicking yourself if you haven’t maximised your allowances in the past. The more you have accumulated in your ISAs, the more you can benefit from this fantastic opportunity.
How normal investments are taxed
Imagine that you have built up a pot of savings of £100,000. The tax you’ll pay on this money depends on the tax wrapper you have selected. Essentially, you have to worry about 2 taxes: income tax and capital gains tax, depending on the wrapper you use.
Here are how some of these wrappers are taxed if your money is not in an ISA.
Bank accounts generate low levels of interest (income) but not capital growth.
Interest earned is added to your income for the tax year. Your bank account interest is taxed last. Your other income will be taxed first. If your other income is fairly low you may pay 0% or 10% income tax on this money. Most people with employment or a pension income would end up paying income tax of at least 20% on their savings. Higher earners pay 40% or 45% on your savings interest.
What this means in practice
Let’s assume an investment of £100,000.
|Gross interest at 2% return||Income tax rate||Tax paid £||Net return £||Net return %|
If your money is in an ISA, you get to keep these returns free of tax. You would get to keep the gross return in the first column, and save the tax paid in the 3rd column. This is a powerful benefit, as it helps you grow your money faster over time. But is not the most powerful benefit. The most powerful benefit is the freedom to withdraw money without attracting tax.
Capital gains tax
Since your bank account does not grow the capital, there is no capital gains tax to pay. This is not a good thing for the long term since your capital is effectively being eroded by inflation as the cost of living eats up your capital.
Bank accounts miss out on the most important feature of ISAs. Since your capital does not grow, the fact that you can withdraw the capital tax-free from your ISA is irrelevant. You have wasted the most important opportunity of your ISA.
Investment accounts are taxed according to the underlying investments. For the purposes of this article I will focus on shares, although bonds, cash and gilts are taxed slightly differently.
Dividend income from shares is now free of tax up to £2,000 for most people. You have no further liability unless the dividend received is greater than £2,000. For dividends over this level you pay tax at 7.5% if it falls into the basic rate income tax band. Higher rate taxpayers are liable to tax on the dividend at 25%. Top rate taxpayers pay tax at 38.1%. This should be declared on your tax return.
What this means in practice
Imagine your investment of £100,000 pays you a dividend of 2%. This may be greater in practice, but it is useful to use this rate compare the tax with that of bank accounts above.
|Gross dividend at 2% return||Income tax rate||Dividend tax rate||Tax paid £||Net return £||Net return %|
This means that dividends are more tax-efficient than bank account interest unless you do not pay income tax. If you combine this with the fact that the income paid by shares is likely to be greater than bank accounts over time, then the greater income benefits from being held in an ISA.
If your money is in an ISA, you don’t get to avoid the 10% tax levied at source. You would get to keep the net return in the fifth column, and save the tax paid if you pay income tax at 40% or 45%. This is a powerful benefit for higher earners, but is not the most powerful benefit. The most powerful benefit is the freedom to withdraw money without attracting tax.
Capital gains tax
Each individual has an annual allowance for gains of £11,700. If you sell units, when switching funds or taking capital withdrawals, you must calculate the gain made between the sale price and the purchase price. Any gains over the annual allowance will be liable to tax at 10% if you are a basic rate income tax payer, or at 20% if you pay tax at the higher rate. Losses can also be offset against gains.
What this means in practice
Imagine your current investment is worth £100,000, but grew from an initial investment of £50,000. That means you have a gain of £50,000 if you withdraw the total £100,000.
|Income tax rate||Capital gains tax rate||Tax paid £||Net return £||Tax as % of total|
Here’s where the most powerful feature of your ISA can benefit you.
If the above investment was held in your ISA then no capital gains tax would be paid. In the above example, you would save between £3,830 and £7,660.
Comparing ISAs to pensions
Pensions are a very valuable way of sheltering money from tax. The major downside of pensions is that you get taxed at income tax rates when you withdraw your money. You do benefit from the 25% tax-free lump sum.
Let’s examine this in practice for a withdrawal of £100,000 from a pension after April 2015.
|Other earnings||Income tax rate||Minimum tax paid on withdrawal £||Net return £||Tax as % of total pension withdrawal||Additional benefit from ISA|
There is more to this matter than just the examples presented here. However, what this shows is that the fact that you can withdraw capital from ISA investments tax-free is a massive benefit to you when you come to draw on your money in the future.
What should you do next?
You should aim to maximise your ISA savings. We do this automatically using our Investment Management service.
If you want to find out more about maximising your investments, just fill out the form below and get instant access to our guide on how to make the most of your investments.
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