How to make the most out of your ISA
It is never too early or too late to invest in an ISA. Each year investors are able to invest up to a certain amount in a tax-free account and the sum for 2017/18 is £20,000. But there are ways you can make more of your ISA allowance, ensuring you hit your long-term savings targets.
There are two different types of ISA: cash, and stocks and shares. So which should you choose? And if you have more that £20,000 to invest, how much should you put into an ISA and how much into other savings and investment vehicles? In fact, first you need to decide how much you should invest, and then where you invest it.
Asset location is not as important as asset allocation. Some studies have shown that asset allocation explains approximately 94% of the performance of a portfolio. But location is still important and can help in maximising a portfolio’s return.
So how do you make the most out of an ISA? Well, everyone has an individual tax position and this needs to be taken into account before decisions are taken. But here are some tips:
- Use Cash ISA for short-term saving: If you’re likely to need money in the short term, then covering those needs using a cash ISA is sensible. Money should be held in stocks and shares ISAs for a longer period of time if returns are going to be maximised and fluctuations in the market ironed out. Having to liquidate a stocks and shares ISA at the wrong time could mean having to liquidate at a loss.
- Sort your ISA early: An investor should utilise their ISA allowance as early as possible each financial year, especially for the Cash ISA since it represents an almost risk-free investment (depending on the credit rating of the financial institution that the ISA is deposited with, of course). For stocks and shares, the argument still holds, but the investor would need to make sure that the market is in line with his or her expectations.
- Think about utilising tax: If you have more than your ISA allowance to invest, stocks should go in the taxable account and bonds should go in the tax-exempt ISA account. This may shock you but it actually make sense. Stocks are more volatile than bonds so you need to share the risk with someone else. By imposing taxes on capital gains, the government is actually sharing the risk with the investor. During periods of high profitability for the investor, the government will earn higher taxes through its capital gains tax regime whilst if an investor records losses during the year, the government will earn nothing during that year and will allow the individual to offset these losses against any future profits.
- Place assets with higher accrued taxes in an ISA: Accrued taxes are those that are paid as and when they arise, such as interest and dividend payments. Depending on an individual’s tax bracket, interest and dividends payments in the UK are taxed at the ordinary tax rate which is usually higher than the capital gains rate with no annual allowances. This means that bonds or bond ETFs would be located more efficiently in an ISA.
- Let yields define asset location: If you have limited space in a tax efficient wrapper then higher yielding assets should be placed in this vehicle where the higher yielding returns benefit from the most favourable tax treatment and lower yielding assets should be placed in the general investment account.
- Put higher appreciating assets in an ISA: This should go without saying. Part of the skill of investing of course is trying to predict which asset will appreciate more during the coming year. The same investor discussed above, who has a current capital gains tax of 20%, has two assets with 15% and 30% expected capital appreciation. But due to ISA restrictions, the investor is only able to locate one of the assets in an ISA. Using the same calculation above and assuming that the investor’s outlook becomes a reality then by allocating the higher appreciating asset to the ISA, the investor would earn 42% compared with 39%.
- Do not put any tax exempt products in an ISA: This may seem obvious all but investors need to pay careful attention to the products that they invest in to ensure that they are making the most of the ISA tax status.
As with all types of investments, you need to monitor your investments regularly in order to ensure that the risk profile of the account has not changed. Minimising costs - both explicit and implicit – will help you maximise your return.
By minimising the taxes and costs you pay, the more funds you will have available for compounding during the following period, therefore increasing one’s chances of earning better future returns.