Isas are all the rage as the start of the new tax year heralds a new opportunity for savers to prevent the tax-man taking a bite out of your money.
The MoneySavingExpert.com inbox has been deluged with questions from users wanting to know where to put their cash, while the website Fairinvestment.co.uk says Isa applications are up 52% since the financial year began on 6 April, compared to this time last year.
But what exactly are the tax benefits of Isas and should you plump for a cash Isa or a stocks and shares version?
How much can you save/invest?
The total Isa limit is £10,200 in any one tax year of which you can deposit up to £5,100 in a cash Isa (see the Full Isa guide).
Cash Isas - the tax benefits
- Key benefit = no income tax. A cash Isa is a normal savings account where the interest is untaxed, though you can only open one per tax-year unless you are transferring cash from previous years (see the Top New Cash Isa guide).
With a normal savings account you generally pay the same tax on interest as your income tax rate if you earn over £6,475 a year. A higher rate (40%) taxpayer who deposits £5,100 would therefore be £65 a year better off a year in an Isa paying 3.2% compared to a taxable savings account paying the same.
Stocks and shares Isas - the tax benefits
These are normal investments such as in shares, funds or bonds, but...
- You pay no Capital Gains Tax (CGT). Normally, when you sell or exchange an asset (eg, shares) you pay CGT at the point of sale but only above the £10,100 tax-free allowance. If your cash grows further, you pay CGT at 18% on the amount above the threshold.
Within an Isa, if the value of your investment rises, the gain is tax-free. On a straightforward £20,000 profit, you'd save £1,782 on the taxable £9,900 uplift in an Isa, assuming you made no gains elsewhere.
- There's usually no tax on interest earned. Some investments, such as corporate bonds, which are effectively loans from you to a company, give you interest in a similar fashion to a savings account, and income tax is deducted from the interest if outside an Isa.
- Dividend income is slashed for high earners. Dividends (income from UK company shares, unit trusts and open ended investment companies) from an Isa investment still attract 10% tax.
This makes no difference to basic rate taxpayers, who will pay that sum regardless, but it saves higher rate taxpayers forking out the full 32.5% outside an Isa or top rate earners paying 42.5%. On a £1,000 dividend, higher rate taxpayers save £225 in an Isa.
Should you save or invest?
The key is your attitude to risk. Martin Lewis, MoneySavingExpert.com creator, explains: "Don't let the tax tail wag the dog.
"First, consider whether you want to put your money in a safe cash Isa or into stocks and shares where you hope for greater return but are willing to take a risk that you may lose money.
"Never choose something just because it is tax-free. For example, if you've used your cash Isa allowance, just because you get the tax-free benefit on an investment, it is not a good reason to invest. You must be willing to risk your money."
What if you're prepared to save and invest?
Let's assume you have a reasonable sum you want to save and invest. Would it be best to use your cash Isa allowance, possibly leaving some of your shares/funds outside an Isa, or should you use your Isa allowance to invest only?
It's impossible to tell you which vehicle (cash or investments) to place more cash into as it depends on how well any investment performs. If it will dive, you're better off saving more. If it will soar, it's better to invest more. But we do not have a crystal ball to hand to help you decide.
But a crucial factor when deciding is considering whether you'll profit from the tax breaks.
- Will you pay Capital Gains Tax outside an Isa? If you have few investments, you would need a large profit to pay CGT outside an Isa as the value of your investment must grow by more than £10,100 at the point you generate the profit (eg, sell your shares). On a £50,000 sum, it would need to grow by over 20% before you're liable for tax.
So unless you make a blockbuster profit, it's unlikely you'll pay CGT on smaller sums at present. If that's you, assuming your cash grows by the same margin as any investment, it may be best to put as much of your money in a cash Isa where you're guaranteed to save on tax.
- Will you earn interest on investments? If you invest in an asset that generates interest (not dividends), such as a corporate bond, that interest is tax-free in an Isa. Outside, you'd pay tax, usually at your income tax rate, unless you earn below £6,475 a year. Therefore, you'll usually benefit from a stocks and shares Isa if it generates interest.
- If you get share dividends, what tax will you pay? If your shares or other investment pays a dividend (such as an income, but not interest), basic rate taxpayers earn no advantage from an Isa but higher and top rate taxpayers can benefit. Under the current tax system, and assuming your investment grows at the same rate as cash, a cash Isa works out best if you're a basic rate taxpayer.
- Is it that simple? Will this always be the case? Not necessarily. Before ignoring investment Isas as a basic rate taxpayer or if you have small sums, remember that if you don't use your Isa allowance you lose it for that tax year.
You may need it in future if you continue investing and so build up a larger pot, if you become a higher or top rate payer or if the Government changes the tax rules. Those over 65 may also get additional tax advantages by investing in a stocks and shares Isa.
Danny Cox, from financial adviser firm Hargreaves Lansdown, also points out that when buying shares, Isa providers sometimes levy a higher fee than they'd charge when buying them outside an Isa, though there is little difference in charges for funds.
Investments can be complicated so for sophisticated investors, there will be many more scenarios to consider. Feel free to discuss those in the link below.
Further reading/Key links