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Why stocks and shares ISAs make sense for UK investors

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Sarah Coles, head of personal finance at Hargreaves Lansdown, looks at why stocks and shares ISAs are a must have for UK investors.

We’re being stalked by the spectre of tax, as stealth taxes and sneaky threshold cuts have snuck up on us and forced millions of people to pay more tax. ISAs remain one of the most powerful ways to protect ourselves from this tax creep, so it’s worth getting to grips with what’s on offer, and just how they can keep the tax attacks at bay.

Five scary tax numbers facing UK investors

  1. £24 billion: By the end of this tax year we’ll pay £24 billion in tax on savings and investing.
  2. £950 billion: The IFS forecasts we’ll pay a total of £950 billion in tax (factoring in all tax) in the coming tax year (2023/24) – 36.9% of GDP. This is the highest level tax has reached since the Second World War.
  3. 2.7 million: people will pay tax on savings in 2023/24.
  4. £6.6 billion: Savers will pay £6.6 billion of savings interest in 2023/24, up from £1.2 billion two years ago.
  5. 635,000: 635,000 more people will pay dividend tax this tax year.

Have the pandemic changes unwound now?

During the pandemic, the number of people investing in stocks and shares ISAs surged spectacularly. Since then, the cost-of-living crisis has taken a toll, but the landscape still looks very different to before the pandemic. The number of active HL stocks and shares ISA clients has grown by more than a third since pre-pandemic.

Despite the addition of more new investors, which naturally lowers the average held by each client, the average ISA holding is higher now than it was before the pandemic.

We also saw more younger people invest in ISAs, and significant numbers remain invested. As a result, by the end of 2023, most HL clients were under the age of 54. Before the pandemic most were age 54 or over.

We have also seen the growth of committed savers signing up to regular savings into a stocks and shares ISA. The cost-of-living crisis means this has fallen back from the pandemic peaks, but still a higher proportion of HL stocks and shares ISA clients are regular savers than before the pandemic.

Where to people invest: top five funds and stocks?

The top five funds held in HL stocks and shares ISAs by the end of 2023:

  1. Fundsmith Equity
  2. Lindsell Train Global Equity
  3. Legal & General US Stock Index
  4. Legal & General International Index Trust
  5. Rathbone Global Opportunities

The top five shares held in an HL stocks and shares ISA by the end of 2023:

  1. Lloyds Banking Group [LON:LLOY]
  2. Shell [LON:SHEL]
  3. Legal & General Group [LON:LGEN]
  4. Tesla [NASDAQ:TSLA]
  5. BP [LON:BP.]

Is a cash ISA still worth it?

When the personal savings allowance (PSA) was brought in, it raised the question of whether cash ISAs were still worth it. Basic rate taxpayers don’t pay tax on the first £1,000 of interest and higher rate taxpayers don’t pay it on the first £500 (additional rate taxpayers don’t get a PSA). The rates on cash ISAs tend to be slightly lower than the equivalent savings rates, so unless they offer tax savings, they may not seem worth the sacrifice.

For years savings rates were so low that basic rate and higher rate taxpayers were highly unlikely to breach their allowance unless they had huge amounts of savings. However, higher rates over the past year have changed the debate and anyone with a decent chunk of savings – particularly higher earners – could have a tax bill on their savings. Rates may have fallen back more recently, but they’re still streets ahead of where they were, so tax remains a key consideration.

But the benefits of a cash ISA don’t start and end with the tax saving today. If the frozen income tax thresholds mean pay rises push you into a higher tax bracket, the ISA will be more rewarding. Likewise, if interest rates rise, you keep building your savings, or the government decides to cut the PSA the way it has done with so many other allowances, you’ll be grateful for your ISA. By using a savings account, average earners with modest savings might be reasonably sure they won’t pay tax on their savings this year. By using an ISA, you can be sure to protect your savings from tax forever.

What taxes are you saving with an ISA?

If you don’t wrap savings and investments in an ISA, there are different kinds of tax due on different things.

Income tax: When you earn more than the personal savings allowance (PSA) in interest on a savings account or peer-to-peer investment, you’ll pay income tax on the rest. The PSA is currently £1,000 for basic rate taxpayers and £500 for higher rate taxpayers – additional rate taxpayers don’t get an allowance.

If you’re using interest from savings to boost your overall income, the frozen tax thresholds mean there’s a risk it will push you into a new tax bracket, so you pay a higher rate of tax. By taking interest from an ISA, this portion of your income will be tax-free.

Dividend tax: When you earn more than the dividend allowance on investments, you’ll pay dividend tax on the remainder. In April, the dividend tax allowance will be slashed for the second consecutive year – to £500, so more people will be paying more tax. In addition, the frozen income tax thresholds will push more people into the higher and additional rates of tax – which will also increase the rate of tax they pay on dividends. Any investments within an ISA is protected completely from dividend tax (you also don’t have to put dividend income on your tax return when it’s in an ISA, saving you the pain of the admin).

Capital gains tax: When you sell up and earn over the capital gains tax allowance (CGT) in profits on investments, you’ll pay CGT on the excess. From April the allowance will be cut from £6,000 to £3,000 – down from £12,300 two years earlier. To make matters worse, the frozen income tax thresholds mean more people will be pushed into the higher rate tax bracket, increasing the rate of CGT they pay.

The parent trap: Savings and investments for children are taxed as belonging to the child, so there’s usually no tax to pay. There’s a major exception to this though – if the parents are putting the money in, then if the child makes interest or dividends of over £100, it’s taxed as belonging to the parents. So, if they’re over their personal savings allowance or dividend allowance, they’ll pay tax on it. A Junior ISA will protect them from this tax charge.

Inheritance tax: It’s not going to be right for everyone, but if you have a large and diverse portfolio, and you are comfortable with the additional risk, you can consider investing in AIM stocks with a portion of your ISA. Some of these stocks have inheritance tax benefits.

What kinds of ISA can you get?

Cash ISA – this is essentially a savings account inside an ISA wrapper – so you don’t ever have to pay tax on interest. You can get a cash ISA from the age of 16 (18 from April).

Stocks and shares ISA – you can hold a range of funds and shares on an investment platform within a single ISA wrapper. This means you’ll never pay income tax or capital gains tax on bond investments, or dividend tax or capital gains tax on stock market investments. You can get a stocks and shares ISA from the age of 18.

Innovative finance ISA – you can wrap peer-to-peer loans in an ISA, and pay no tax on returns. These are very different to savings accounts, because they’re investments that involve more risk. The target rate you see is not guaranteed. From April providers will also be able to offer access to Long Term Asset Funds. These offer sophisticated and higher risk investment opportunities in areas like private equity, infrastructure and real estate. These have previously been hard to reach for retail investors, and until now they couldn’t be held within an ISA. IFISAs will also be extended to include open ended property funds. However, we believe this is not the way to invest in property because of liquidity concerns. We think closed ended funds are a better to get pooled exposure. These are available through a stocks & shares ISA.

Junior ISA – this is for children aged 0-18. Any money you put in is tied up until the age of 18, at which point it belongs entirely to the child. You can get a cash JISA or a stocks and shares JISA.

Lifetime ISA – these come as either cash LISAs or stocks and shares LISAs. If you’re aged 18-39, you can open a Lifetime ISA and the government will top up all your contributions by 25%. You can use it to buy your first home (although you must hold the account for at least a year before you do this), or withdraw once you are 60. If you withdraw money for any other reason, you will pay a penalty.

Help to Buy ISA – this is closed to new entrants, but if you still have one, you can continue paying into it until November 2029 and claim a bonus until November 2030. It’s a cash ISA, designed to help first time buyers save for a deposit. When you buy a property, the government adds a 25% bonus. If you withdraw the cash for any other reason, there’s no bonus. In the current tax year, you can’t pay into a Help to Buy ISA in the same year you pay into any other cash ISA.

How much can I put in this year?

The tax year begins on 6 April, and ends the following 5 April. Each tax year, you have an overall ISA allowance. This year it’s £20,000, and you can divide it between a cash ISA, stocks and shares ISA, Innovative Finance ISA, Lifetime ISA, and Help to Buy ISA. In the current tax year, you can only pay into one ISA of each type in each tax year. From April 6 this rule will be dropped.

You can put money into both a LISA and a Help to Buy ISA, but it’s not recommended, because you can only get a bonus for a house purchase on one or the other.

Within the overall allowance, you can put up to £4,000 a year into a LISA, or £200 a month into a Help to Buy ISA.

In addition, children have a £9,000 JISA allowance.

Should I pay into a Lifetime ISA or a pension?

When you pay into a pension you get tax relief at your highest marginal rate – so 45%, 40% or 20%. Non-taxpayers also get 20% tax relief, although their annual allowance is lower (£3,600). It means that higher and additional rate taxpayers get far more free money from the government through a pension than a LISA.

In addition, if you’re employed, then assuming you’re old enough and earn enough, you’ll automatically be enrolled into a pension, to which your employer has to contribute. It means that the pension is better for these people too – at least for the first slice of their retirement savings – because the extra cash going in is likely to outweigh any tax they pay when they withdraw it.

In some cases, when you pay extra into your pension, your employer will pay more in too, so it’s worth making the most of these extra contributions – to get as much free money from your employer as possible.

If you’re self-employed, you won’t automatically be enrolled into a pension, and you won’t get any employer contributions. It means that if you’re a 20% taxpayer, and will still pay tax in retirement, you’re probably better off overall with a LISA – provided you’re eligible. You’ll get the same tax relief, but when you take the money out, once you reach the age of 60, all the money coming out of a LISA is completely tax free, whereas only a quarter of the money coming out of the pension is. You won’t necessarily pay tax on all of the rest, but you’re likely to pay tax on some of it.

Likewise, if you’re a basic-rate taxpayer, and have already paid into your pension and topped it up to maximise the employer contributions, you may want to redirect any additional retirement savings into a LISA if you think you’ll pay tax in retirement.

You can pay up to £60,000 a year into a pension and £4,000 a year into a LISA. You may be able to use carry-forward rules to pay more in, or pay into your spouse’s pension, and you may also be able to make use of your LISA allowance.

Can I transfer an ISA?

Yes. You can transfer between ISAs of the same type, and between different types of ISA – so cash to stocks and shares and vice versa.

There are some key things to note

It’s vital not to cash the ISA in and try to move the money, or it will come out of this year’s allowance. Instead, contact the provider you want to move to and ask them to make the transfer. Not all ISA providers accept transfers in.

Innovative finance ISAs are more complicated. Any money sitting in cash with these ISAs can be transferred straight away, but you might not be able to transfer when money has been loaned out. Check the policies of your provider.
If you want to transfer from a cash or stocks and shares ISA to a Lifetime or Help to Buy ISA, you can only transfer up to the annual limits for these kinds of ISAs – and the amount you transfer will come out of this year’s LISA or Help to Buy ISA allowance.

In the current tax year, if you’re transferring money paid in during previous tax years, you can either transfer it all, or just transfer part of it. If, however, you want to transfer money you paid in this year, you’ll have to transfer it all. From April 6, this rule will be dropped.

What happens to your ISA after you die?

When you die, your ISA becomes a ‘continuing account of a deceased investor’ or a ‘continuing ISA’ for short. No more money can be paid into it at this point, but while your estate goes through probate, if it rises in value, this growth will be tax free.

Once probate is completed, if it is being passed to anyone other than your spouse it may be subject to inheritance tax (IHT). If it is passed to your spouse, however, not only is there no IHT, but they will get an additional ISA allowance – known as an additional permitted subscription. This is equal to the value of cash or investments passed on, or the value of the ISA on the date of death – whichever is higher – so they can wrap everything back up in an ISA without using up their annual allowance.”

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This article does not constitute investment advice. Do your own research or consult a professional advisor.

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