Tuesday 10 March 2020 11:37 am

Your road map to the Isa universe: Make the most of your tax-free allowance

Luke is a former City AM features writer, now features editor for Tyto PR

There are just 27 days to go before the tax year ends on 5 April. For savers and investors, that means there are only a few weeks left to make use of their Individual Savings Account (Isa) allowance. 

Introduced in 1999, Isas allow people to invest up to £20,000 into savings each tax year, and prevents tax from eating into their profits. The allowance resets each year, so it is good practice to make the most of it every time. 

In the past, Isa investments were limited to cash savings or the stock market, and were intended for general savings. But the Isa market has expanded to include new categories (such as peer-to-peer lending) and serve different purposes (such as Lifetime Isas, which can be used exclusively for retirement savings or to buy a house). You can divide your allowance between these different options as you see fit.

Given all of these options, the Isa universe can be a little confusing, especially for first-time savers. Hopefully, this article will guide you through your choices and help you make the most of your allowance. 

Cold, hard cash

Cash Isas offer interest payments free from income tax, which is 20 per cent for basic rate taxpayers, 40 per cent for higher rate taxpayers, and 45 per cent for additional rate taxpayers (those earning more than £150,000 per year).

They are probably the most straight-forward Isa product. However, this tax incentive has become less useful since the introduction of the personal savings allowance in April 2016, which permits basic rate taxpayers to earn up to £1,000 in savings income tax-free. Higher rate taxpayers can earn up to £500, but additional rate taxpayers do not get a personal savings allowance, so a cash Isa may be useful for them.

The other problem with cash Isas are the relatively poor returns. Currently, the average interest rate for an instant-access cash Isa is 0.83 per cent. With UK inflation last measured at 1.8 per cent, this means cash Isa savings are technically losing purchasing power.

Still, there are good reasons to keep some cash assets, such as an emergency fund or when saving for the short term. Cash savings are also predictable; your savings will increase by the advertised interest at a set time, whereas stock market investments can go up or down in value.

Also, cash Isas are simple to set up, as many high-street banks offer them. Fixed-rate Isa accounts, where money is locked away for a year or more, usually offer higher rates of interest than instant-access accounts, which allow any number of withdrawals.

Currently, the top easy-access cash Isa is from Virgin Money. It pays 1.31 per cent a year, but only allows a maximum of two withdrawals every 12 months. Cynergy Bank is close behind, with an Isa paying 1.29 per cent with unlimited withdrawals. OakNorth Bank offers fixed cash Isas paying 1.41 per cent and 1.51 per cent if you’re willing to lock your money away for one or two years. 

Some banks offer additional incentives to encourage savers to open cash Isas. For instance, Nationwide recently launched a cash prize draw: anyone who saves £100 in one of its Isas before 30 April will have a chance to win one of 60 prizes worth between £5,000 and £20,000. Nationwide offers a one-year cash Isa paying 1.21 per cent which allows up to three withdrawals.

Ride the stock market

While cash Isas are predictable, the returns are very low. People who are able to save for the long term may be better off investing their money into a stocks and shares Isa.

These investments usually involve buying company shares that may pay dividends, or bonds (a loan to a business or government) that pay interest. 

Investments in a stocks and shares Isa are free from capital gains tax, which is otherwise charged at 10 per cent for basic rate taxpayers and 20 per cent for higher rate taxpayers for any gains above the yearly allowance of £12,000. Interest from bonds are also tax-free.

Changes to how dividends are taxed, introduced by the former chancellor George Osborne, made Isas more appealing for investors. Prior to April 2016, all dividends were taxed 10 per cent at source, even on investments held within Isas.

Now, all dividend income from an Isa is tax-free. Outside of an Isa, dividends above £2,000 per year are taxed 7.5 per cent for basic rate taxpayers, 32.5 per cent for higher rate taxpayers and 38.1 per cent for additional rate taxpayers.

Of course, stocks and shares Isas involve some element of risk. Markets can go down as well as up, and companies can go bust, meaning that investors will likely lose all their money. Anyone who has paid attention to the news recently will know that stock markets around the world have fallen sharply in the last few weeks because of fears about the spread of coronavirus. 

As such, first-time investors must be aware that their capital is at risk and their investments may end up being worth less than they put away to begin with, whereas cash deposits are secure — although data shows that stocks and shares have historically beaten cash over the long term.

For example, according to figures provided by Fidelity, a £10,000 investment held in cash for 10 years would be worth £10,194 now, while the same investment into the FTSE 100 would be worth £18,027.

“While there is less risk associated with holding money in cash, the current low interest rate environment means that any gains will be minimal — particularly with speculation that the Bank of England may reduce the base rate further within the next month or so,” says Tom Stevenson, investment director at Fidelity Personal Investing. “Investing in markets can pose a greater level of risk, however they can also offer greater returns.”

One other element to be aware of is that, unlike cash Isas, stocks and shares Isas are not free. Investment platforms usually charge a percentage fee for their service each year, which is taken by selling part of the customer’s investments. 

These fees are usually very small: Fidelity charges just 0.35 per cent, which equates to £35 per £10,000 saved with the platform. For smaller portfolios, percentage fees won’t cost a lot, but they can add up as a portfolio grows. If you put your money into funds, investment trusts, or exchange traded funds, there’s usually an additional management charge. 

There are also dealing costs to consider. For instance, buying shares, investment trusts, or exchange traded funds with Cavendish Online costs £10 per deal. However, there are new providers offering cheaper trading fees, such as the challenger fintech Freetrade, which charges zero dealing commission fees on its app-based platform (although its Isa account costs £3 per month).

Traditional investment platforms like Fidelity, Cavendish Online, and Hargreaves Lansdown are popular with DIY investors who want to pick and choose where their money is invested, but this can be daunting for some savers.

Thankfully, there are alternatives. Robo-investment platforms have emerged in the last decade that make investing less complex and manage your money for you. These providers include Moneyfarm, Nutmeg and Wealthify, which all offer Isa accounts. 

Usually, new customers will complete a questionnaire to identify what level of risk they are comfortable with, what their investment goals are, and how long they intend to invest. The platform will then allocate their money into different assets accordingly. This extra management does come with a slightly higher cost: Nutmeg charges 0.75 per cent on a fully managed portfolio worth up to £100,000 (the fee decreases on larger portfolios), but you are paying to not have to pick stocks yourself.

So what stocks and shares Isa should you go with? That depends. Do you want to manage your investments yourself, or go with a robo-adviser that does it for you? One platform that charges a lower percentage fee may have higher dealing costs than another. A cheaper platform might have a smaller choice of available investments than another. As such, investors need to shop around and do their homework before deciding.  

Pensions versus Isas

Readers may wonder whether they should invest into an Isa or a pension. After all, pension contributions benefit from tax relief, which is worth from 20 per cent to 45 per cent, depending on what rate of income tax you pay. 

However, pensions cannot be accessed until you are at least 55, and income from a pension will be taxed when you come to collect it. The rules for pensions are also particularly complex: the annual allowance is tapered for higher earners, and there is a lifetime allowance of £1,055,000 — any pension savings above this will incur tax charges of up to 55 per cent.

Isas offer flexibility and simplicity. The returns are tax-free, there’s no cap on how large Isa savings can grow, and the money can be withdrawn at any time (with some exceptions), which is useful if you have an emergency. 

Of course, it is not a case of either or. Both serve a purpose, depending on your financial priorities: for instance, an Isa will help you with saving up for a house deposit, while a pension is crucial for your retirement planning.

Taking Aim

While discussing stocks and shares Isas, it is worth mentioning the UK’s Alternative Investment Market (Aim). This is an index of the country’s smallest listed companies, which have the potential for rapid growth. You’ve likely heard of some Aim stocks, such as the online fashion retailers ASOS and Boohoo, or the tonic water maker Fevertree.

In addition to the benefits listed above, Aim stocks held within an Isa are also free from inheritance tax. These will be useful to some investors who want to pass on more of their wealth to their family.

However, investing in individual Aim stocks can be risky. These are small companies, usually in the early phase of growth, so their share price can fall fast if they run into trouble. As such, it may be best to consider investing in an Aim-based fund that spreads your money around several companies — this diversification reduces your risk. 

A fund will also employ a professional manager who will be able to pick and choose investments. Several asset managers, such as Octopus, offer Aim Isa funds.

Nest egg

Speaking of families, if you are a parent and want to put money away for your child, a Junior Isa is a good place to start.

Junior Isas are tax-free savings accounts for children. Parents can save or invest up to £4,368 a year, and choose to divide this allowance between a cash Isa or a stocks and shares Isa. 

While a Junior Isa is opened and managed by a parent, the account is in the child’s name meaning that the money belongs to them — control of the account switches to the child when they turn 18. It can’t be accessed until the child reaches that age — so no, you won’t be able to tap into the Isa to buy your kid an early birthday present.

Junior cash Isas are very similar to their adult equivalent, although they usually offer a higher rate of interest. For instance, Coventry Building Society offers an account paying 3.6 per cent interest a year.

Again, a stocks and shares Isa may be a better choice. Because the money cannot be accessed until the age of 18, this offers a much longer time frame for the child’s investment to grow, and even if markets did fall sharply at some point, their investments will likely have time to recover before they access the money. 

By saving a small amount regularly into a Junior Isa over 18 years, you could be able to give a child a potentially life-changing amount of money to help them on their journey into adulthood. According to AJ Bell, parents who put away £75 a month into a stocks and shares Junior Isa from their child’s birth would have an account worth over £24,000 by the time they turned 18 — that’s enough for a 10 per cent deposit on an average priced UK property.

The property ladder

As mentioned above, there have been some new additions to the Isa universe. The Help To Buy (H2B) Isa and Lifetime Isa (Lisa) were introduced in 2015 and 2017 respectively.

These were designed so that people can make tax-free savings that can be used for buying their first property, or go towards their retirement.

The H2B Isa allows people to put up to £200 a month in cash savings, and then obtain a 25 per cent bonus if the Isa is used to buy a property. The bonus is capped at £3,000 on savings of £12,000 or more in total. This type of Isa is now closed to new applicants, but if you do still have one, check what rate your account offers. You could transfer it to HSBC, which offers 2.25 per cent each year.

The H2B Isa has effectively been replaced by the Lisa. This account allows you to save up to £4,000 a year in a cash or stocks and shares account, and the government adds a 25 per cent bonus to your contributions. The bonus is paid each year until you turn 50, and the maximum bonus is £33,000 (if you open one at 18 and make the maximum contributions). You can only open a Lisa if you’re aged between 18 and 39. 

However, there are limits on how you can use the Lisa. You can withdraw money from it when you turn 60, or  use it towards a housing deposit if you’re a first-time buyer. If you withdraw the money at any other time, you’ll face a penalty of 25 per cent, and because of how this is calculated, you actually lose 6.25 per cent of your original contributions, not just the 25 per cent government bonus.

Moneybox offers a cash Lisa paying 1.4 per cent. AJ Bell and Hargreaves Lansdown offer stocks and shares Lisas where you pick the investments, or there’s the robo-advisor Nutmeg, which will manage your Lisa money based on your attitude to risk.

Innovative ideas

Finally, there’s the Innovative Finance Isa (Ifisa), another new type of account introduced in 2016. It was launched to provide a tax-free wrapper for savings income from peer-to-peer (P2P) lending.

P2P services connect lenders directly to borrowers, cutting out the banking middleman. By directly lending money to individuals or businesses, lenders can earn much higher interest rates than if they put their money into a bank. 

Your money is lent to borrowers over periods ranging from six months to five years. The loan is then repaid monthly, plus interest. These interest payments are free from income tax if held within an Ifisa.

A range of P2P lenders have launched in the UK over the last 16 years which now offer investments within the Isa tax-free wrapper. Zopa was the first P2P lender to reach the UK in 2005. It offers projected returns of 3.4 per cent to six per cent. Funding Circle launched in 2010, connecting lenders to small local businesses. It offers projected returns of 4.5 to 6.5 per cent after fees and bad debt. 

“The Funding Circle Ifisa allows investors to earn inflation-beating returns — without the extreme price movements that we are currently seeing with stocks and shares — while lending directly to creditworthy small businesses,” says Lisa Jacobs, UK managing director of Funding Circle. “Over the last 10 years, more than 80,000 investors have earned over £300m in net interest. While investors earn, the economy grows as the businesses they lend to create thousands of jobs — for every £1 lent through Funding Circle, £2 is added to the UK economy.”

While the projected returns from P2P lending vary, they can be less volatile and more predictable than investing in the stock market, while still offering much better interest rates than cash Isas. 

There are still risks. Because your money is lent out for a set term and then drip-fed back to you each month, it can be difficult to get it back quickly if you need it for an emergency. Depending on the provider, if you do need your money back, you can sell your loans — although this usually incurs a cost (Zopa charges a one per cent loan sale fee), and can take a couple of weeks. 

P2P lending is a relatively new asset class, and there are questions over how the various providers will cope through a particularly severe market downturn or recession, especially if several of their borrowers default. However, to help reduce risk, these providers do ensure that investors’ money is diversified by lending small amounts to hundreds of businesses. This helps to avoid volatility.

Happy saving

So there’s your road map to the Isa universe. Hopefully, it will help you decide where you want to invest your money and benefit from the tax savings. 

And while the end of the tax year is imminent, don’t rush. It’s best to think about where you want to place your savings, and how much you can afford to save, rather than making a knee-jerk decision that’s not right for you in the long run.

Main image credit: Getty