In the next few weeks, all UK adults will have the chance to either ‘use it or lose it’ with regards to their ISA allowance for the current tax year. Any amounts not credited to an ISA before the 5 April deadline will have to go towards next financial year’s ISA allowance or else be invested via a share dealing account.
While this isn’t a disaster, since investing outside of an ISA is straightforward, it does mean fewer tax advantages. For example, ISAs incur zero capital gains tax and the dividends received don’t contribute towards an individual’s annual income for the calculation of dividend tax. And with dividend taxes due to rise moving forward, ISAs could become a useful means for income investors to record higher net cash flow than they otherwise would be able to via a share dealing account.
As well as their tax advantages, ISAs also offer a huge amount of flexibility versus a traditional pension. That’s because once cash is credited to an ISA it can easily be withdrawn at any future date. This is useful because it makes it easier to retire early since an individual’s pension is always accessible, while for younger people it’s especially helpful because tying up cash for 40 years or so can seem rather daunting. That’s especially the case when housing, transport and other costs seem to mount up throughout life.
Tax now, or later?
Certainly, a traditional pension offers front-end-loaded tax relief, in terms of amounts credited not being subject to income tax. However, money withdrawn from a traditional pension is taxed, so while ISAs don’t offer front-end-loaded tax benefits, their withdrawals are tax-free and in the long run this means that there’s no difference between the two.
For example, assuming a 20% tax rate and 5% growth rate over a 20-year period, £1,000 invested in a traditional pension would grow to £2,653 and then be taxed to give a net figure of £2,122. In an ISA, £800 would be invested (since there’s no initial tax relief), but it would grow to a figure of £2,122 which could then be withdrawn tax-free.
As well as tax benefits and flexibility, ISAs are also cheap and easy to set up. The annual management fee can be as low as the cost of one trade, while opening an ISA is often no more challenging than opening a share dealing account.
Clearly, investing right now may not seem like a great idea to many investors, with the FTSE 100 having disappointed thus far in 2016. However, with the UK’s main index having delivered an annualised total return of over 9% since its inception in 1984, in the long run, investing in shares through an ISA seems to be a sound means of planning for retirement.
