Filed your tax return? It’s time to focus on your ISA

No matter how large or small your savings, the ISA is a very powerful long-term savings and investment tool. If you don’t use your 2017/18 allowance, you lose it.

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ISA: savings and investment

Whether you use an accountant or not, managing your finances throughout the tax year is a time consuming business. Come 31 January, and the scramble to have met the self-assessment deadline means there is a risk that financial fatigue could set in.

When filing your tax return, at the bare minimum you rely on your employer to send you a P60 (legally this has to be by 31 May), outlining your pay and benefits. If you have investments, your provider’s tax statement will summarise your realised gains and losses, and split out whether dividend income has come from UK or overseas companies. You may also need to claim relief on charitable donations, pension contributions and, should you have one, the income and expenses on a buy-to-let property.

Assuming you have avoided a £100 fine for late submission (according to HMRC, 768,905 returns were submitted on deadline day in 2017), to breathe a sigh of relief and lose focus now could be a great mistake, as the preparation you put in between now and the end of the tax year on 5 April, will determine the size of your tax bill in 2018/19. 

Pension allowances should be utilised where possible, the tax-free allowance for capital gains crystallised, and the ISA allowance made full use of.

The ISA allowance: use it or lose it

No matter your income or wealth, the ISA allowance makes for a very attractive tax-free savings tool. While pensions have been effectively capped at £1 million ( inflation linked) before an onerous 55% tax charge comes into play, the £20,000 individual allowance for 2017/18 has been maintained for 2018/19, meaning that a couple that haven’t used any of this year’s allowance could conceivably save £80,000 over the next few weeks.

Unlike pension allowances, ISA allowances cannot be carried forward. Therefore if you don’t use it this tax year, there is no chance to make use of it next year.

In the image below we can see that the ISA allowance has risen sharply from £7000 in 2007/08 to £20,000 in this tax year. This compares very favourably with the capital gains tax (CGT) allowance, which rises annually in line with inflation, and for many investors has been dwarfed by stock market gains. 

At present, CGT is just 20% on shares (28% on buy-to-let property), the legacy of the March 2016 treasury decision to ‘ensure that CGT provides an incentive to invest in companies over property’. This makes tax-free gains in ISAs interesting, but not critical for the majority of investors. Nevertheless, those with a longer memory will remember that as recently as 2007/08 the top rate of CGT was 40%, and it would come as no real surprise if a future UK Government looked to reduce the gap between taxes on capital gains and income, hugely increasing the attractiveness of ISA savings.

It’s fair to say too that the previous Labour government was not especially friendly to the ISA investor. Between 1999 and 2010, the ISA limit rose by a modest 2.9% from £7000 to £7200, while inflation, as calculated by the retail price index (RPI), was up by 35%. Investors may see something similar occur in the future.

Pay no income tax within an ISA

Dividend and interest income is free of tax within an ISA, which at present is a major attraction for savers and investors. In 2018/19 the tax-free dividend allowance is being cut from £5000 to £1000, making the ISA an even more attractive tax shelter for dividend income.

To put this in perspective, the FTSE 100 currently yields roughly 4%. Next year anyone holding more than £25,000 in a FTSE 100 exchange traded fund (ETF), outside their ISA, would have the balance of their dividends taxed at either 7.5%, 32.5% or 38.1%, subject to their tax band.

In the table below, we can see how this works in practice. An individual paying 40% income tax would have their dividends over £1000 taxed at 32.5%. Therefore to get a post-tax yield of 4%, they would need an initial yield of 5.93%, an effective dividend uplift of 48.3%.

Dividend Tax Rate FTSE 100 yield (ISA) Non-ISA equivalent yield Effective ISA yield boost
7.5% 4% 4.32% 8%
32.5% 4% 5.93% 48.3%
38.1% 4% 6.46% 61.5%

 

Whether you are able to save £1500 a month, or £150 a month, steadily accumulating savings within an ISA is worthwhile due to the long-term effects of pound cost averaging.   

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