Are ISAs tax free?

Could opening an ISA help to cut an individual’s tax payments?

Man holding piggy bank with text “Are ISAs Tax Free?” and The Motley Fool jester cap logo

ISAs – or individual savings accounts – are a great way to protect your wealth from tax. Whether you’re thinking of opening an ISA or rechecking the ISA rules, we’re here to help. In this guide, we break down everything you need to know about the tax-free status of ISAs.

Are ISAs tax free?

In the main, yes. Any interest, capital growth or dividend income on assets held in an ISA are tax free. This means that ISAs can be a great way to save on tax and grow your wealth over time.

How much tax can you actually save with an ISA?

A tax-free ISA sounds like a great deal, but how much money can you actually save? Let’s take a look at the normal tax rates you would pay outside of an ISA account. For simplicity, all data presented below assumes you’re a basic rate taxpayer.

Type of tax Amount you’d pay outside of an ISA account
Interest Income Tax 20% of anything over the £1,000 allowance
Dividend Tax 7.5% of anything over the £1,000 allowance
Capital Gains Tax 10% of anything over the £1,000 allowance

As you can see, you would actually save a good amount of money in an ISA account compared to a regular taxable account.

What is the tax-free ISA allowance?

The tax-free ISA allowance is currently £20,000 per person per tax year. The current tax year runs from 6 April 2021 to 5 April 2022. That means a couple can save up to £40,000 between them without paying any tax on their interest or dividend income.

You can save your whole personal allowance into one ISA or split it across different types of ISAs. However, you can only pay into one of each type each tax year.

But what about existing ISAs? Are ISAs tax free if they’re from a previous tax year? The answer is yes. You’re allowed to keep existing ISAs and save into a new ISA as long as you don’t invest in the old ISA in the same tax year. For more detail, see our article on how many ISAs you can have.

You’re also allowed to transfer your ISA to another provider. Any transfers aren’t counted as part of your annual ISA allowance.

Do you have to pay tax on ISA withdrawals?

You don’t have to pay tax on ISA withdrawals, including on any interest, other investment growth or dividend income in your ISA. Because assets held within an ISA are protected from Income Tax, National Insurance and Capital Gains Tax, you’re able to withdraw from an ISA whenever you need to.

However, there could be other penalties or fees for taking money out of certain types of ISAs, so be sure to keep that in mind if you’re considering a withdrawal.

Are ISAs exempt from inheritance tax?

Unfortunately, ISAs aren’t exempt from Inheritance Tax, and normal Inheritance Tax rules will apply.

If you leave your ISA to someone who isn’t your spouse, they may have to pay Inheritance Tax. The amount of tax payable depends on the total value of your estate and your other circumstances.

If you haven’t ever married, then you will get a tax free ‘nil rate band’ of £325,000. If you were previously married, then you may also get an additional ‘transferable nil rate band’ from your spouse.

If you inherit an ISA from a spouse, then there is also a little-known tax rule where you may be able to use their ISA allowance on top of your own. This is known as the additional permitted subscription.1 It means that you may have a one-off additional ISA allowance on top of your own £20,000 allowance. This additional allowance is based on the value of your spouse’s ISAs when they die.

The Inheritance Tax rules are complicated, so it’s worth seeing a specialist solicitor for detailed advice. They can assess your circumstances and explain how the rules apply to you.

What about Capital Gains Tax on ISAs?

Are ISAs tax free when it comes to Capital Gains Tax? The answer is yes. Saving or investing in an ISA protects your investments from Capital Gains Tax. This could be a big potential saving as outside of an ISA account,  you’ll need to pay Capital Gains Tax on capital gains over your annual exemption of £12,300 per year.

So what does that mean savings-wise? If you’re a higher rate taxpayer, then you’ll owe 28% on capital gains from residential property and 20% on any other gains. So, for example, if you sold some shares held outside an ISA and made a gain of £20,000, then you would owe tax of £1,540. That’s a lot of money saved in an ISA!

Do you have to declare an ISA on your tax return?

You don’t need to declare an ISA on your annual tax return. No interest or dividend income within an ISA counts as part of your taxable income.

Are there any other tax benefits?

There are some other tax benefits of ISAs that are less well known. Here are two that are worth being aware of.

High Income Child Benefit Charge

Because ISAs reduce your taxable income, they may affect your eligibility for Child Benefit and other means-tested benefits. Working parents earning over £50,000 (including wages, interest and dividend income) have to pay back some of their Child Benefit through the High Income Child Benefit Charge. There’s a sliding scale until workers earning over £60,000 have to repay all their Child Benefit.

Depending on your circumstances, using an ISA means you might be able to reduce your earnings below £50,000. This is because interest or dividend income earned in an ISA isn’t counted as part of your taxable income.

National Insurance hike

Interest and dividends earned within an ISA are free of National Insurance as well as Income Tax. That means you’ll be able to protect investments owned within an ISA from the National Insurance hike that’s coming in April 2022. From April, National Insurance due on dividend income outside an ISA will be charged at 8.75% rather than the current 7.5%.2

Kickstart your tax savings today

Overall, an ISA is a great way to protect your finances from tax. If you’re ready to begin your saving journey, check out our list of the featured stocks and shares ISAs in the UK and get started today.

Sources

  1. “Manage additional permitted subscriptions into an ISA” – gov.uk
  2. “National Insurance” – gov.uk

The content in this article is provided for information purposes only. It is not intended to be, nor does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.