What is an Individual Savings Account (ISA)?
An Individual Savings Account (ISA), is a “wrapper” for cash or investments which confers some potentially valuable tax benefits to UK resident savers and investors.
The basic rules
The legislation authorising ISAs was introduced in April 1999 and replaced the forerunners of the ISA, which were Personal Equity Plans (PEPs), introduced in January 1987, and Tax Exempt Special Savings Accounts (TESSAs), which were introduced in January 1991. All previous PEPs and TESSAs are now ISAs.
It is a common misconception that the Government provides some form of guarantee with ISAs, but this is not the case at all. The Government’s only role is in granting the tax status. Generally, ISAs are covered by the Financial Services Compensations Scheme (FSCS) as deposits or investments, but, this needs to be checked carefully. For example, there is a new breed of ISAs that are regularly advertised and which offer high interest rates – “Earn up to 7% p.a.” one advert reads. These are “Peer-to-Peer” or “Innovative Finance” ISAs and are not Cash ISAs in the normal sense. Subject to the FSCS limit, the money in a Cash ISA is guaranteed. However, the money in this new breed of ISAs is not guaranteed. The capital invested is at risk if the business to which the money has been lent defaults and the schemes as a whole are not covered by the FCSC if the Provider defaults.
With the reintroduction of ISAs in 2014, the rules have been completely simplified. Prior to 01 July 2014 there were strict rules about separate Cash and Stocks & Shares ISAs, but these have all been swept away with a new, single annual Allowance of £20,000 (2020/21). So long as the overall Allowance isn’t exceeded, the saver/investor can choose the amount they want to keep in cash, what they want to invest and can switch between cash and investment components without restriction. Additional rules came in from April 2016 to allow money withdrawn from an ISA to be replaced during the same Tax Year, without affecting that year’s allowance. If you want to take advantage of this facility, check first, because not all Providers of investment (Stocks & Shares) ISA facilitate this option.
The foregoing is in relation to “adult” ISAs, but there are also Junior ISAs, which can be opened on behalf of any child under the age of 18. Whilst the annual allowance is £9,000 (2020/21), as opposed to £20,000, in every other respect the same options and benefits apply as with adult ISAs.
The tax benefits
The tax benefits of an ISA are that interest (but not dividends on shares) is eligible for a tax repayment within the ISA and both interest and dividends can be paid-out or accumulated without any personal tax liability. Furthermore, realised profits on investments within an ISA are not subject to Capital Gains Tax. Equally, any realised loss made on an investment within an ISA cannot be offset against taxable gains elsewhere.
With effect from 15 August 2013, the schedule of allowable investments was extended to include shares quoted on the Alternative Investment Market (AiM). The added benefit of this is that, not only are the returns on such shares sheltered from personal taxes within the ISA, but the shares can also qualify for Business Property Relief for Inheritance Tax after just 2-years of ownership. This is a highly complex and specialist area of financial planning upon which professional advice should always be sought – see my blog.
The only exception to the statement about Government guarantees is the Lifetime ISA (LISA), which replaced the Help to Buy ISA in April 2017. This is a cash or stocks and shares ISA in every other regard, but will benefit from a Government 25% uplift in the amount saved. There are of course, rules.
The following apply to LISA generally:
- Only available to those aged 18 and over, but below 40.
- Maximum contribution is £4,000 per annum.
- Maximum savings are £32,000.
- The bonus is 25% of savings, payable annually after the account has been open for 12-months.
- The bonus is withdrawn if the funds are not used for home purchased or retirement – see below.
The following apply to LISA for home purchase:
- A strict definition of first-time buyer applies.
- The property must not cost more than £450,000.
The following apply to LISA for retirement:
- The funds cannot be accessed penalty-free until age 60+.
Unfortunately, there are very few Providers that have made accounts available.
What happens on death?
A further reason for holding an ISA was introduced in the Autumn Statement on 03 December 2014, namely the ability for a surviving spouse or civil partner (together just referred to as “spouse”) to inherit an additional ISA Allowance on death.
As you would expect, there are some rules to comply with to obtain this potentially hugely valuable tax concession, including:
- The spouse makes an application to the Manager holding the ISA assets.
- The new subscription is made no more than 3-years from the date of death.
- The value of the Allowance, which is in addition to the usual annual Allowance, is the value as at the date of death or the date of transfer, if higher.
In common with all ISAs, an account comprising inherited assets can be transferred to another provider. Consequently, where the existing ISA does not offer a suitable range of investment for the spouse – risk profile, diversification, appropriate returns, etc – then the account can subsequently be transferred to another, more suitable provider.
How should I use an ISA?
Whilst the ability to accrue interest tax-free in an ISA is attractive, longer-term, cash on deposit has never offered any degree of inflation protection – see my blog.
Additionally, the introduction of the Personal Savings Allowance – £1,000 per annum for a Basic Rate Taxpayer and £500 per annum for a Higher Rate Taxpayer (2020/21) – has made Cash ISAs largely redundant for most savers, other than those with exceptionally large cash reserves or those paying Income Tax at the Additional Rate.
The very name, “Stocks & Shares” ISA, can put some people off, because it sounds inherently risky. There is no doubt that any form of investment carries a degree of risk. Even cash has a degree of risk, particularly, as I have already commented upon, an inflation risk, i.e., that the buying-power of your savings, despite the addition of tax-free interest, can be less in the future. However, the extensive range of investments available within a Stocks & Shares ISA means that a portfolio can be created that suits virtually every risk profile, from the lowest to the highest.
If you have existing ISAs, either cash or Stocks & Shares, you want to reviewed, please complete the contact form below and I’ll create a link for you to our risk profiling tool, which will help us – you and I – to establish your attitude to risk. Beyond that, if you wish, I can analyse existing investments to see if they fit in with your stated attitude to risk.