As Benjamin Franklin famously said, ‘there are only two certainties in life: death and taxes’. While little can be done about the former, an ISA can help to reduce the latter.
The most popular ISA is a cash ISA, which offers tax advantages when compared to a savings account. Stocks and shares ISAs offer tax-efficiency with regard to dividends and capital gains tax, while a lifetime ISA offers a government bonus in addition to the tax efficiency of stocks and shares ISAs and cash ISAs.
Over the years, the options available and the amounts that can be invested in an ISA have changed. However, the tax efficiency of an ISA remains robust, and for this reason alone it could be worth considering for a wide range of individuals.
For the 2020 tax year, an individual can invest up to £20,000 in an ISA. This can be apportioned between different types of ISAs, such as a cash ISA and a stocks and shares ISA. However, the total amount invested must not exceed £20,000 per year. In the case of a Lifetime ISA, no more than £4,000 can be invested per year.
No tax is paid on interest income received within a cash ISA. This may sound highly appealing, but the reality is that it has become less enticing following a period of low interest rates, as well as wider tax changes.
Today, a cash ISA is likely to offer an interest rate of around 1.5%. Since the first £1,000 of interest income received by an individual outside a cash ISA is tax-free, an investor would need to have around £67,000 in a cash ISA in order to benefit from its tax status when compared to a savings account.
Stocks and shares ISAs offer significant benefits from a tax perspective with regard to capital gains. No capital gains tax is charged within an ISA. This could mean that an individual avoids either a 10% or 20% tax rate on realised gains, depending on whether they are a basic rate or higher-rate taxpayer respectively.
This could provide significant savings for individuals in the long run, even though there is an annual capital gains tax allowance of £11,700. This allowance means an individual can make a capital gain on the sale of assets (excluding their primary residence) of up to £11,700 per year before tax is payable.
While the first £2,000 of dividends received by individuals outside a stocks and shares ISA are tax-free, above that they are taxed at 7.5% or 32.5% depending on whether an individual is a higher or basic-rate taxpayer. Within an ISA, no dividend tax is levied, and any dividends received do not count towards the £2,000 annual allowance. For an investor who is planning to use their ISA in order to generate a second income, or for retirement purposes, this could make a significant difference to their long-term income.
A lifetime ISA offers the same tax advantages as a stocks and shares ISA and cash ISA, with it being possible to invest in shares or keep the money in cash. As mentioned, the annual allowance for a lifetime ISA is £4,000. For every £1 that is contributed, the government offers a 25% bonus. This means that an individual could obtain up to £1,000 in bonuses per year.
A lifetime ISA is, however, more restrictive than a cash ISA or a stocks and shares ISA. For example, it is only available to individuals under the age of 40, while withdrawals can only be made after the age of 60 (unless they are used to pay for a first home, or in the case of terminal illness). The bonus is paid up until age 50, which means that as much as £32,000 in bonuses are available over an investor’s lifetime.
ISAs are tax-efficient products that are also relatively straightforward to open and administer. They have a generous annual allowance and could save an individual significant sums of money during their lifetime. Cash ISAs may have lost much of their appeal due to tax changes and low interest rates, but stocks and shares ISAs and lifetime ISAs could be enticing financial products for many individuals.
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