You are probably familiar with cash individual savings accounts (Isas) and stocks-and-shares Isas, but the past few years have seen a proliferation of a number of other types of this tax wrapper. So in the forthcoming 2017-18 tax year there will be no fewer than six different versions of this tax wrapper. But while choice is good, it will be more important than ever to pick the right one for you and have the right number.
Within a single tax year you can pay your annual allowance, currently £15,240, into three different types of Isa. You can fund a cash or Help to Buy, stocks and shares, and Innovative Finance Isa. And from April, when the annual allowance rises to £20,000, you will also be able to open the Lifetime Isa (Lisa) designed for those between 18 and 40 to either save for a home or retirement.
What's the point in cash?
Cash or investments sheltered in an Isa grow free of tax. The introduction of the fairly generous personal savings allowance has dented that appeal because since April 2016 basic-rate taxpayers have been able to earn £1,000 in interest on cash before paying any tax, and higher-rate taxpayers have been able to earn £500 before paying any tax. However, after that higher-rate taxpayers would pay 40 per cent tax on interest and additional-rate taxpayers have no personal savings allowance so pay 45 per cent on all savings interest.
At the current interest rates offered by cash, a basic-rate taxpayer would have to save a significant chunk to accrue interest over £1,000. But Danny Cox, chartered financial planner at Hargreaves Lansdown, still thinks cash Isas are worthwhile. "The tax advantages of sheltering your cash accumulate, so the more money you have sheltered from tax, the greater the savings," he says. "The interest rate you are receiving on cash Isas may not look appealing at the moment but at some point interest rates will rise, and by keeping cash in an Isa you will never have to worry about the tax implications."
But Jason Hollands, managing director at Tilney Group, says that "cash Isas are effectively a busted flush, offering dismal interest rates at a time of rising inflation which means negative real returns".
You can get a better rate on a cash Isa if you are willing to tie your money up for longer. But with the possibility of interest rate rises in the near future it could be better to keep your money in easy-access Isas and wait for better rates.
Rates on instant-access cash Isas
| Provider | Interest rate (%) | Further information |
|---|---|---|
| Paragon Bank | 1.05 | |
| Virgin Money | 1.01 | Only three penalty-free withdrawals per year |
| NS&I | 1.00 | Interest rate drops to 0.75% AER on 1 May |
| Saga | 0.95 | Includes 12-month bonus of 0.90% |
| The Coventry | 0.90 | |
| Post Office Money | 0.90 | Includes 12-month bonus of 0.65% |
Source: Moneyfacts and Moneysavingexpert
When to buy an innovative finance Isa
On 6 April 2016 the government launched the Innovative Finance Isa (Ifisa), which enables investors to lend their money via peer-to-peer (P2P) platforms tax-efficiently. It is now possible to hold an Ifisa, stocks-and-shares Isa, and cash Isa in the same tax year and split your allowance between them. Since November, the scheme has been broadened to enable investors to hold crowd-funded debt securities such as bonds within the wrapper too.
The main attraction of P2P lending is the high interest rates on offer, with platforms advertising rates of between about 3 and 9 per cent. But these are not guaranteed rates of return, but rather expected rates of return, which do not account for potential losses or selecting the wrong businesses, so P2P lending can be a far riskier proposition than investing.
The person or business you lend to could default, and unlike investments covered by the Financial Services Compensation Scheme (FSCS) you are not entitled to any protection if one of the companies involved fails. However, you are unlikely to find rates this high anywhere else, meaning that for many people it could be worth putting a small chunk of your portfolio into this area.
"Anyone looking to dip their toe into this area shouldn't put more than 5 per cent of their portfolio into it, although the exact allocation depends on an individual's capital position," says Mr Cox. "P2P should be seen as broadly akin to a fixed-income investment portfolio and treated as such in terms of risk and return."
A number of P2P platforms have launched Ifisas, including Landbay, Lending Works, and LendingCrowd. However, many others are still waiting to receive authorisation from the Financial Conduct Authority (FCA).
Landbay was one of the first to launch, having been granted Isa manager status by HM Revenue & Customs in January this year. Its Isa requires a minimum investment of £5,000 and offers an expected annualised return rate of 3.75 per cent. LendingCrowd's Ifisa requires a minimum investment of £1,000 and has a targeted rate of return of 6 per cent per year.
Different platforms offer loans to different types of borrowers: for example, Landbay focuses on the buy-to-let sector, while Lending Works facilitates personal loans to individuals.
Innovative Isas available/expected to launch
| Provider | Targeted return |
|---|---|
| Abundance Investment | 2% AER on balances till 31 May 2017. Estimated returns of 6 - 9% a year |
| Crowd2Fund | Estimated 8.7% APR return |
| Crowdstacker | Estimated returns of up to 7% a year |
| Downing | Expected before 2016/17 tax year end |
| Landlord Invest | Expected returns up to 12% a year |
| Landbay | Expected return of 3.75% annualised per year |
| Lending Crowd | Expected returns of 6% a year |
| Lending Works | 3.8% rate up to 3 years and 4.5% up to 5 years |
Source: Investors Chronicle/providers
First-time homebuyer Isas
First-time home buyers can make use of Isas specifically for this purpose, which benefit from a substantial government bonus.
The Help to Buy Isa was launched on 30 November 2015 and is open to new applicants aged over 16 until December 2019. But this is a cash Isa, meaning the person in whose name it is opened cannot fund another cash Isa within the same tax year. The Help to Buy Isa allows you to pay in £1,200 in the first month and £200 per month thereafter, and you receive a government top-up of 25 per cent on your cash when you buy a home. The minimum you need to get the bonus is £1,600 and the maximum house price it can be used for is under £250,000, or £450,000 in London.
Next month the government will also launch the Lifetime Isa (Lisa), which enables those aged between 18 and 40 to open a Lisa, which will enable them to save a greater amount than with a Help to Buy Isa. You can make Lifetime Isa contributions and receive a bonus from the age of 18 up to the age of 50.
You can invest the Lisa in cash or stocks and shares, and save either for a house or for retirement. The annual saving limit is £4,000 per year, compared with £2,400 for a Help to Buy Isa, and you could receive a much larger bonus as you could save for longer, meaning you will have a much larger pot with which to receive the bonus on.
If you, or your child, is not planning to buy a house within five years, stocks and shares are likely to be better for generating long-term returns.
"The Lifetime Isa for a first-time buyer seems like a no brainer," says Mr Cox. "You won't be able to use the bonus for the first 12 months, so it is important to know how long you will be saving for. Most people will be saving for a property for many years - at least five - in which case stocks and shares will get a better return than cash."
If you are helping a teenager or grandchild on to the property ladder you cannot open a Lisa in their name, but could gift them the cash they need to build it up. You can gift £3,000 a year without it counting towards the value of your estate. Gifts of a larger sum are exempt from inheritance tax if you survive for seven years after the gift was made.
But consider carefully whether you, or your relative, is definitely planning to buy a house, as there could be hefty penalties if you take the money out early or for another purpose. You cannot take out partial withdrawals in year one of the Lisa and will face exit penalties if you do not use the money for a home or retirement after 2017-18. "The Lisa is great if you will be buying a house, but that is it," says Petronella West, chartered wealth manager at Investment Quorum.
If you don't use the Lisa money for a house purchase, you will be charged a 25 per cent penalty if you try to take the money out before age 60, with the exception of the 2017-18 tax year - the first year of the scheme.
Even if you plan to open a Lisa, there is an argument for opening a Help to Buy Isa before the end of this tax year, saving the maximum into it and then transferring it into a Lisa after 6 April. This is because over the 2017-18 tax year you will be able to move your Help to Buy Isa cash into a Lisa without it counting towards the Isa limit, meaning you could benefit from the government bonus on both schemes.
Time taken to build up average house deposit of £32,321 in a Lifetime Isa*
| Personal contribution each year | £4,000 | £4,000 |
|---|---|---|
| Government bonus each year | £1,000 | £1,000 |
| Type of Lisa | Equity Lisa returning 5% per annum | Cash Lisa returning 1% per annum |
| 1 year | £5,200 | £5,040 |
| 2 years | £10,710 | £10,140 |
| 3 years | £16,496 | £15,292 |
| 4 years | £22,570 | £20,495 |
| 5 years | £28,949 | £25,750 |
| 6 years | £35,646 | £31,057 |
| 7 years | na | £36,418 |
Source: AJ Bell
*Average deposit for first-time buyers in 2016 according to Halifax
Think of your Isa like a pension
If you have a large pension pot and a large amount in Isas, it makes sense to consider the two holistically for tax purposes as Isas and pensions have different tax benefits.
You can draw money out of an Isa without incurring income tax, while with a pension you can take a lump sum out worth 25 per cent of the total fund tax-free, after which withdrawals are taxed at your marginal income tax rate. This means that in some cases it may make sense to draw tax-free income from your Isa in retirement and save your pension to pass on to beneficiaries. Pension freedoms legislation introduced in April 2015 abolished the so-called 55 per cent death tax on pensions as long as an individual dies before 75 and the pension pot has not yet been accessed. If the pot has been accessed and the individual dies after 75, the beneficiary pays income tax at their marginal rate on lump sums and when drawing down income from the pot.
However, with regard to inheritance tax (IHT), Isas count towards your estate.
"Isas are great for growth, but if you plan to leave them to grow untouched you are compounding a potential IHT bill for your beneficiaries," says Gary Smith, chartered financial planner at Tilney Group. "Whereas if you leave your pension to grow and generate your income from Isas in retirement, you can avoid that. Isas are a great way to save tax-efficiently, and an even better way to generate an income in retirement and improve your IHT position."
How to manage your stocks-and-shares Isa
When investing in a stocks-and-shares Isa don't pack it with too many holdings and dilute the impact of each one. "A good rule is to have no more funds in your Isa than you have fingers and thumbs," says Mr Cox. "The danger is that when you go beyond 15 fund holdings, it gets unmanageable, so I think 10 is a good number."
Mr Smith adds: "You've got to have conviction and believe in what you're investing in. For example, if you have 100 shares, when one share goes up 20 per cent you've only made a 0.2 per cent impact on your portfolio, and it doesn't grow by much."
But as your Isa portfolio grows your need to diversify increases. "Too often investors continue to build up portfolios dominated by one or two investments," says Adrian Lowcock, investment director at Architas. "To be successfully diversified means investors should have a good spread across asset classes, sectors and funds. A portfolio should not have more than 10 per cent in any one fund, and hold between about 10 and 20 funds."
A good strategy with an Isa is to build up a core of funds that give you well-diversified exposure to a mix of global equities and a range of asset classes. When you have a good core, you can consider adding small additional 'satellite' exposures to via individual shares and countries you want to take more targeted bets on.
If you have a substantial Isa fund and are concerned about IHT, you could consider putting a chunk of it into Alternative Investment Market (AIM) shares because they qualify for business property relief (BPR). Once held for two years they are no longer considered part of your estate in the IHT calculation.
One way to invest in Aim companies in an Isa portfolio is through a managed Aim portfolio run by a specialist provider. These tend to hold portfolios of between 20 and 30 shares and employ teams of tax specialists.
"Small companies carry the risk of default or collapse, so this is definitely not an area without risk, but is something that we see used for estate planning," says Mr Smith. "We would say that, typically, you should have at least about £50,000 in your portfolio before you consider investing in Aim, and you could consider putting around 10 to 15 per cent of this in, depending on your attitude to risk."
Consolidating Isas
If you have accrued Isas from multiple places over the years it could make sense to transfer them into the same place. Transferring old Isas does not count towards your annual allowance, and you could benefit from greater flexibility and lower fees on a DIY Isa wrapper, as well as benefiting from potentially lower charges on larger pots and the administrative ease of having all your investments in one place.
However be aware of the charges you could face when transferring out of an Isa. For example, Hargreaves Lansdown charges £25 per holding when transferring out stocks and £25 to transfer out a stock as cash, while Halifax Share Dealing also charges £25 per line of stock to transfer out.
But a few providers will cover some of the costs of a transfer for you - for example Fidelity Personal Investing. See more on this in our guide to Isa charges on page 28.
