The world of Isas was once a sleepy one. At every Budget, the chancellor would typically increase the amount you could contribute each tax year by some measure of inflation. You had a simple choice between putting that money into a cash or a stocks and shares Isa (or a slightly restrictive combination of the two). And the benefits that the Isa offers (no tax on capital gains and interest, in particular) have always been well-understood by savers. But Isas are sleepy no longer.
First, in 2014, the chancellor liberalised the rules, jacking up the amount you can contribute each tax year (it’s £15,240 per individual in 2015-16, so £30,480 for a couple) and allowing savers to put as much of that allowance into cash or stocks and shares as they wished. Other changes like the launch of the Help to Buy Isa (with government top-ups for first time buyers), the fully-flexible Isa (permitting savers from next month to withdraw and replace cash without eating into their annual allowance), and the Innovative Finance Isa (which will extend the wrapper to peer-to-peer loans) have all added to the mix.
Is the revolution over? Not yet. While further reforms to Isas are not expected in the Budget tomorrow, and the chancellor has already announced that the annual allowance won’t be rising in 2016-17, other changes could have a big impact on how you can make the most of your Isa in the coming tax year.
Cash Isas lose their appeal
Unless you’re a 45p taxpayer, the cash Isa is set to become much less attractive. This isn’t just because returns are so poor – although top cash Isa rates are currently only about 1.4 per cent – but also because the new Personal Savings Allowance will come into effect next month. This will enable higher rate taxpayers to earn £500 in income from ordinary bank and building society accounts, government or company bonds, and most life annuities without paying any tax. Basic rate taxpayers get £1,000 tax-free, but 45p taxpayers get nothing.
Since the best non-Isa current accounts are paying 3 per cent interest on savings, unless you earn a very large amount in interest each year, getting a paltry rate from a cash Isa will not be the good deal it once was. “Cash Isas are pretty redundant for all but the most well off,” says Adrian Lowcock of Axa Wealth. Research earlier in the year from Savings Champion found that a higher rate taxpayer, gaining 1.55 per cent annual interest, will only breach their £500 Personal Savings Allowance if they hold more than £32,258 in their account.
Innovative Finance Isa
So if you can, depending on when you will need the money, it makes more sense to put your full Isa allowance to work either in a stocks and shares Isa or in the new Innovative Finance Isa – which will cover investments in peer-to-peer loans once the platforms have received FCA approval.
“Peer-to-peer is an asset class with very interesting qualities,” says Ian Peacock, head of UK at IG. “If you stick with a platform at the higher end which has a provision fund, you can get a yield of about 5 per cent with very little default risk. And importantly, returns are not correlated with equities.”
Lowcock is less keen. “The issue is that this is a relatively new area in personal investing and has not been through a market cycle. That matters because a full recession will reveal any weaknesses in the system which won’t appear at other times.”
In the tried and tested world of equities, there’ll be change for Isa investors too. From next month, the new Dividend Allowance will be introduced, which will allow investors to earn £5,000 a year in dividends outside the Isa wrapper tax-free. Tax rates are very high over this limit, at 32.5 per cent on dividend income above £5,000 for higher rate taxpayers and 38.1 per cent for additional rate taxpayers, but it represents a sizeable tax break for anyone relying on investments for part of their income.
How does this affect Isas? Some argue that it means you should devote any new Isa contributions solely to growth stocks or funds. But Danny Cox of Hargreaves Lansdown sounds caution about putting too much faith in this new tax-free allowance. “The big overriding thing is that, if you hold investments within the Isa, you avoid future chancellors (or even the current one) deciding to make changes. He could cut the Dividend Allowance before it comes in, he could increase capital gains tax.” Indeed, he says, even if you decide to keep income-paying assets outside your Isa, the likelihood is that at some point you will want to rebalance those assets, and when you do so you will be likely to pay tax on any capital gains.
There is some concern that the flurry of changes to the Isa are undermining one of its most attractive characteristics: its simplicity. With the new Help to Buy Isa, for example, there are restrictive rules over how much you can contribute each month, when you will get a top-up from the government, and the price of the house you can subsequently purchase.
But Isas remain Britain’s best-loved tax-free savings vehicle. Even if you do simply end up putting your money in a cash Isa, that money will be free from taxation forever and the Isa tax benefits can now even be passed on to a spouse when you die. “The beauty of the Isa is that, once you’ve paid into it from taxable income, it allows you to grow your assets free of taxation,” says Tony Stenning of BlackRock. “Any sum you eventually take from it, you can withdraw tax-free.”