ISAs GUIDE 2015 An introduction to Individual Savings Accounts
ISAs GUIDE 2015 Introduction Most people s experience of saving starts in childhood. Your parents encourage you to save up a few pennies, perhaps in a jar or piggy bank, then eventually spend your hoarded cash on a treat. We get taught saving as a child because saving money becomes important in adulthood. Our savings will help us steer a course through uncertain events like losing a job or an illness - as well as more predictable ones such as getting married, children, house purchases and eventually retirement. The good news is that a while ago the government decided that saving was good for the UK economy too so good, in fact, it wanted to reward everyone for doing it. The reward is simple: keep your savings as cash or shares in a government-endorsed ISA pot and you won t have to pay tax on any interest or capital gains you get from storing your money there. And with income and capital gains tax being a constant drain on investment returns for many, you may want to think seriously about what ISAs can offer as a possible storage pot for your loot. We hope this guide will help you understand more about how ISAs work and how they might benefit you. Adam Price Founder, VouchedFor 1 ISA. /ʌɪsə/ (in the UK) an individual savings account, a scheme allowing individuals to hold cash, shares, and unit trusts free of tax on dividends, interest, and capital gains; in 1999 it replaced both personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs).
1. What is an ISA? The term ISA stands for 'individual savings account' and, in the briefest possible terms, presents a tax-efficient way to save money. They were introduced on 6 th April 1999 by the government as a measure to encourage people to save. There are various reasons for this, including the theoretical benefits to the economy that come with increased investment, and the idea that if people put money aside they will be less likely to have to lean on the government for benefits should things go badly wrong. They play a counterpart to another mainstream tax-efficient investment product, a pension scheme. One way to think about the difference between an ISA and a pension is that with an ISA you will have already paid tax on money you put in to it, while with a pension you don't pay tax on your contributions (to be more specific, the government 'tops up' your contributions with the amount you would have paid in tax had that money not gone into a pension). Let's say you pay tax as you earn it from your employer. So when you receive your pay slip every month, it will have had a certain amount of tax deducted from it. It's out of that already-taxed money that you make contributions to an ISA. However, because you pay tax on the way in, you don't pay tax on the way out, i.e. when you sell the assets the ISA is invested in. More on that later. In contrast, with a pension you don't pay on the way in, but you pay tax on the way out usually if you try to take more than your 25 per cent tax-free lump sum. But that's another story. 2
2. How do they work? An ISA is what people in the industry call a 'wrapper' which is a way of grouping together underlying assets. In a cash ISA this will be unsurprisingly cash, and in a stock and shares ISA this will be equity in businesses or other underlying assets. The main draw of an ISA is that it provides a certain amount of tax relief to the saver. With typical, everyday bank accounts the kind that you use to pay bills, make online purchases, and cover the expenses of everyday life you will usually receive a small amount of interest. However, this interest will be taxed at your marginal rate of 20 per cent for basic taxpayers and 40 per cent for higher rate taxpayers. So let's say you have 100 in a current account with your local bank or building society. If it pays you 2 per cent interest, you would have 102 after one year, before tax. However, if you are a basic rate taxpayer the interest will be taxed at 20 per cent, meaning you will pay 40p of that 2 to the government, leaving you with only 101.60. Admittedly these are very small amounts in this example, but remember that this example is a small sum for simplicity. Over several years and if you are dealing with larger amounts, this can add up significantly. Interest earned on an ISA is not taxed, so after one year with 100 and the same interest rate (for simplicity's sake) you would be left with the full 102. Note however that ISAs will often pay slightly better interest rates than current accounts, although this may not always be the case and will vary from one provider to another. Things become a little more complicated with a stocks and shares ISA, but there are still tax efficiencies for savers to enjoy. First, capital gains tax: usually you would pay tax on the gains (or profit) from selling as asset, be a property, piece of art, or an investment. However, when you sell the investments held in a stocks and shares ISA, you don't have to pay capital gains tax on the profits you make on this. Also keep in mind that you can make 11,000 of capital gains in the 2014/15 tax year before having to pay tax on it, regardless of whether or not it's held in an ISA. Second, income tax: usually, you would pay tax on any dividends you get from shares you own, or interest paid to you (see above). However, in a stocks and shares ISA the basic rate of tax has already been paid for you by whoever issues the dividend payments, at a rate of 10 per cent instead of the basic rate of 20 per cent. You don't have to pay anything else. Note however that if you do not pay any tax at all (i.e. are a nil-rate taxpayer) you cannot claim this 10 per cent back. In the case of investing in cash, property, gilts (government bonds) and corporate bonds, growth is paid as interest rather than dividends. You don't pay any tax on this either because the issuing company will claim back all tax on your behalf, irrespective of the level of tax you pay. 3
One more tax-related note: you don't have to even mention your ISAs in your tax return for the purposes of capital gains or income tax, making your return generally easier to fill out each year. 4
3. What are the ISA limits? You can't just pour all your money into an ISA and avoid paying tax on capital gains and interest. Both cash and investment ISAs have limits. Until last year, you could save 11,520 into an ISA, and of that only half ( 5,760) could be in cash. But in 2014 chancellor George Osborne announced that not only would the ISA limit be raised to 15,000, but savers would be allowed to keep as much of that in cash as they wanted. In July 2014 the limits were raised to this new threshold and you can currently save 15,000 into an ISA, split however you like between stocks and shares and plain old cash. However, how much you can save into an ISA the ISA limit can change from year to year. The precedent is that it will rise in line with inflation but this is not set in stone. For the 2015-2016 tax year the limit will rise to 15,260. It s good to be aware that the limit does change and to keep abreast of changes as they are announced. 5
4. What types of ISAs exist and which types are most popular? There are two basic types of ISA, a cash ISA and a stocks and shares ISA. Let's talk about each of these in turn. CASH ISA A cash ISA, as explained previously, is a deposit account usually run by a bank or building society that offers tax-free saving. It will keep your initial investment intact i.e. there is no risk of losing capital to poorly performing investments however it will be eroded by the implacable force of inflation. This means that if you deposit 15,000 in an account for several years, that same amount will have less borrowing power as it did initially because prices have gone up slightly each year since it was deposited. A cash ISA from a given provider will usually offer a better interest rate than similar taxed accounts from that same organisation. Some ISAs are 'instant access', allowing you to withdraw cash as and when you please. Others require you to lock cash in for a certain amount of time. A junior ISA, meant for saving on behalf of a child, cannot be accessed until the child turns 18 for example. STOCKS AND SHARES ISA A stocks and shares ISA can hold investments including one or more funds, or individual stocks and shares in what is called a self select ISA. This type of investment carries investment risk, meaning that if the underlying investments perform poorly it's possible you could lose your original investment capital and get less back than you put in. However, with greater risk comes the potential for greater return, and if your investments do well you may come out with significantly more than you would have from a cash ISA. Also, keep in mind that because you hold trade-able securities in your stocks and shares ISA, your capital will generally be insulated from the effects of inflation that erode the value of basic cash. Stocks and shares ISAs should generally be seen as medium to long term investments. 6
If you want better access to your money a cash ISA might suit you better. However, if you want to invest seriously or don't intend to access your ISA for at least five to ten years, you might consider opting for a stocks and shares ISA. People under 16 can qualify for a junior ISA as long as they weren't born between 1 September 2002 and 2 January 2011. The ISA must be opened by an adult with parental responsibility for the child, and the maximum annual contribution is now set at 4,000. This will increase to 4,080 in the 2015-2016 tax year (from 6 th April 2015). One last thing to note is that you may see ISAs increasingly referred to as 'NISAs'. This stands for new ISA, and refers to the changes proposed by Chancellor George Osborne in his 2014 Budget. 7
5. Who benefits from ISAs? In principle, pretty much everyone should be saving for the future rather than living pay cheque to pay cheque, and ISAs fill a nice space between the current account which is for short-term spending and a pension, which can't be accessed until you reach retirement age. So is there anyone who should not be saving into an ISA? Aside from those in debt... no. Even if you don't come anywhere near to reaching your annual limit, and even if you're too nervous to risk having a stocks and shares ISA and want to keep all your holdings in cash, you will still benefit over the long term from the tax breaks. Obviously in order to save you have to be able to afford to contribute, but even a handful of pounds a month is better than nothing, and you will be pleasantly surprised at how quickly that adds up. Remember because you're not paying tax on interest or capital gains, your returns will compound leading to a significant benefit over the long term. For example if you earn 2 per cent interest on 100, you will earn 2 the first year, 2.04 the next, then 2.08, 2.12, 2.16 and so on until what seemed like a minor difference had added up to a whole lot more than it started out as. 8
6. How should I choose one? There are a few things to consider when choosing an ISA, including what rate you're going to earn for cash, what the charges are on an investment ISA, and what restrictions are placed on how and when you can get your money back. Think about your goals: is this a long-term savings product, or is it something you want to draw from every once in a while when you need a bit extra? Although the principle of an ISA is simple, there is quite a variety available on the market. If you're not sure what you want you should consider speaking to an Independent Financial Adviser (IFA), who will have knowledge of the entire ISA universe and will be able to make a specific recommendation based on your personal circumstances. 9
7. How can I manage my ISA? ISAs are relatively straightforward investment products, and there are many places where you can buy and manage an ISA yourself, completely online. This might include online investment platforms such as Interactive Investor or Hargreaves Lansdown. Many will offer tools to determine your risk rating, and model portfolios that match that rating so you don't have to worry about choosing which individual stocks you think will perform. You're not a fund manager after all, and even fund managers have trouble timing the market. There are also offline options. If you have your ISA with a bank or building society chances are you will be able to make changes or deposits at your local branch. Many ISA providers also offer services over the telephone. However, if you aren't comfortable picking your own investments outside of a cash ISA and want to invest with the blessing of a professional, you may want to consider a face-to-face meeting with a financial adviser. 10
8. What recent changes have taken place? Previously, your ISA allowance was just over 11,000, and would rise in line with inflation. Also, you could only hold up to half of your allowance in cash. One of the ideas behind this was to encourage everyday people to invest, which would in theory help businesses prosper and also help people save more money so they might not have to lean on the government in the case of an emergency or later in life. However, Chancellor George Osborne gave ISAs a significant boost in his 2014 Budget. Not only did he raise the annual limit to 15,000 but he proposed that a saver should be able to invest as much or as little in cash. So while before you could only put in a few thousand pounds of cash every year, from now on you will be able to divide your ISA savings up any way you like between investments and cash. 11
9. How much do they cost? Cash ISAs should cost you absolutely nothing to set up, or to deposit money into, but may have charge you for switching into a better-paying account or withdrawing your money early. A stocks and shares ISA on the other hand will almost certainly have annual and initial fees attached to it. The initial charge will be up to 5.5 per cent or so to buy into the fund, and every year an annual management charge of up to 1.5 per cent will be deducted to cover the costs of running the ISA. In the case of a self-select ISA, where the investor hand-picks the contents of his or her ISA, you will still generally pay an annual fee, which might be a fixed amount of anywhere between 15 to 100 a year, and possibly waived if you invest the full allowance each year ( 15,000 at time of writing). 12
10. What are the potential pitfalls or risks? It's not a pleasant thing to say, but the truth is your money is never safe, not even when it is being held in cash. One of the main risks of having a stocks and shares ISA is investment volatility. Your money isn't being held in a bank account but in a selection of stocks and shares whose value depends on what other investors are willing to pay, which itself is affected by how in-demand the shares are, which is affected by how well the company performs and what its perceived growth projections are and so on and so on. The value of stocks and shares can go up and down. If you plan it well or pay for the services of a discretionary manager, you might be able to hedge your investments so that not all of them will drop in value at the same time. But remember if they all travel together then the good days will be even better and the worse days will be even worse. If they are hedged so some go up when others go down this might protect against dips in the market but could also dampen gains. Remember, you are never guaranteed positive returns, nor even getting back what you originally put in. However, the risk of losing everything, or even coming out with less over the long term, is probably not so great to put you off. An independent financial adviser will be able to either help you choose the investments according to your goals and risk profile i.e. how much risk you are willing to take and how much money you can afford to lose or at least point you in the direction of someone who can. You can avoid investment risk by holding your money in cash. However, this comes with a different risk inflation. Inflation is the gradual reduction in value of currency. Typically inflation only goes one way, so what you can buy with 100 one year is slightly more than what you can get with the same amount a few years later. If you hold all your ISAs in cash and inflation hits a high note for several years in a row, that can seriously chip away at the value of your holdings. 13
11. Should I seek advice or do things myself? When choosing your ISA you might want to go it alone, but might be better off considering the services of an independent financial adviser, or IFA. Although ISAs are relatively simple investment products, there are still several things to consider, including what rate the ISA provider is willing to pay you. Although you might be tempted to simply walk into your local bank or building society, or even go one step further and look on an online investment platform, keep in mind that only an IFA will look at the entire universe of ISAs on offer and decide what is best for your circumstances and investment goals. An IFA will also be well-versed in the different characteristics of various products on offer, for example how long you would need to lock your money away. If you're considering a stocks and shares ISA, then an IFA could be even more useful. Many advisers can either help you choose which investments to hold in your ISA or at least point you in the direction of someone who can. 14
12. Conclusion When navigating the sea of savings and investment products an ISA or NISA might seem like a good port of call and for the majority of savers it is indeed a good place to start. Created by the government to encourage saving and investing, the benefit of tax free returns on your savings should not be under-rated. However, as we ve covered in this guide, like all savings and investments they are not without risk. Every individual s case is different, but unless you re in debt, the bottom line is that the earlier you start saving the better. 15
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