- Isas are an integral part of financial planning
- Consistency and time are key for wealth creation
In 1999, the speculative fad-based investing of the dotcom bubble was reaching its apex, and Bill Gates’ (then the richest man in the world) net worth topped $100bn thanks to the soaring value of Microsoft (US:MSFT) stock. Tony Blair was presiding over Cool Britannia and Westlife’s ‘I have a dream’ spent four weeks at the top of the UK charts. Brussels popped the champagne as the euro was introduced after many years of preparation.
The UK savings industry, meanwhile, was having a little cultural revolution of its own. In April 1999, Gordon Brown, then UK chancellor, introduced the individual saving account (Isa) to “get Britain saving again”. Isas replaced personal equity plans (Peps) and tax-exempt special savings accounts (Tessas), with the key advantage of enabling people to access their money at any time, while also allowing savings to grow free of income tax, capital gains tax and dividend tax.
Isas gradually became the savings staple of the UK public and are now subscribed to by millions every year. According to a paper published by the Office for National Statistics last year, between 10m and 15m Brits have been putting money into Isas on an annual basis over the past two decades, with the market value of all adult Isa holdings totalling £584bn in 2019.
As the UK savings ratio (household saving as a proportion of income) has had a bumper year over the pandemic, increasing from 9.6 per cent in Q1 2020 to 29.1 per cent in Q2, perhaps the 2020-21 tax year will prove to be one of the more fruitful years for the Isa wrapper, while the events of the past year have underlined the value of saving for a rainy day.
Key Isa facts
In its simplest form, the Isa is a wrapper that allows you to grow savings free of tax. You have an annual Isa allowance, which is the amount you can add in any given year. The current allowance is £20,000, a level it has been at since 2017.
|Types of tax||Basic-rate taxpayer||Higher-rate taxpayer||Additional-rate taxpayer||Isa investor|
|Capital gains||10 per cent||20 per cent||20 per cent||0 per cent|
|Dividend||7.5 per cent||32.5 per cent||38.1 per cent||0 per cent|
|Income (paid on fixed rate products)||20 per cent||40 per cent||45 per cent||0 per cent|
All UK residents can have Isas, while junior Isas are available for children under the age of 18, and must be set up by a parent or legal guardian before the child is 16. The current Junior Isa allowance is £9,000 a year. From 16, you can open your own cash Isa and from 18 you can open a stocks-and-shares Isa, innovative finance Isa (IFIsa) and lifetime Isa (Lisa) if you’re under the age of 40.
The two main types are stocks-and-shares Isas and cash Isas. In 2019, cash Isa holdings accounted for 46 per cent of the market value of Isa funds, and stocks-and-shares Isas accounted for 54 per cent. Having only been introduced in 2016, innovative finance Isas made up only 0.1 per cent.
By opting for a stocks-and-shares Isa, you can grow your money over time and benefit from compound growth. If you put £20,000 into an Isa at the start of every year, for example, and the investment grew by 4 per cent per year, after 20 years your portfolio would be worth £619,384. After 28 years, you’d have over £1m – and almost half of it would be taxable if it were not inside an Isa.
According to IG, FTSE 100 total returns grew at an annualised rate of 7.75 per cent from 1984 to 2019. If you invested £10,000 every year and it compounded annually at 7.75 per cent, you would have double the nominal amount you paid in after 13 years – £260,010 in total.
If you have a low risk tolerance or think you might need access to your Isa money within the next five years, it might be more sensible to put money into a cash Isa. Cash Isas currently pay very low levels of interest, so the tax benefits may be minimal, but it is good to keep as much money as possible within the wrapper, as once the tax year has ended (5 April) you can’t use up that year’s allowance.
There are some other types of Isa you can consider. Lisas, which replaced ‘Help to Buy’ Isas, were designed to help people with a property purchase. You can set one up between the ages of 18 and 40, and put up to £4,000 into it each year. You can keep contributing until your 50th birthday, and the government will add an extra 25 per cent, up to £1,000 a year. As with all Isas, it is free of UK tax. The government will pay the bonus each month (or however often you pay into your account), and your platform or bank should claim the bonus for you. However, Lisas can catch people out (see ‘Watch out for Lisa’s sting’ overleaf).
Innovative finance Isas are for peer-to-peer lending – where you directly lend money to borrowers and businesses for a fixed amount of time and they pay you back with interest.
Interest rates can look generous on these products, but generally the higher the rate, the greater the risk you will lose money.
|Types of Isa|
|Stocks & Shares ISA||Investment account||£20,000 allowance, no dividend tax or CGT payable|
|Cash ISA||Savings account||£20,000 allowance, tax free interest|
|Lifetime ISA||Savings/ investment towards house deposit or retirement||£4,000 allowance, govt adds 25% to contribution. Bonus paid back if not used for house purchase (first time buyers only) or retirement. Only those aged 18-39 can open. Tax free returns|
|Innovative Finance ISA||Peer to peer lending||£20,000 allowance, tax free interest|
|Junior ISA||Savings or investment account for children (up to age 18)||£9,000 allowance, tax free returns|
|Help to Buy ISA||Savings account for first time buyers||Closed to new savers. Can pay in £2,400 for 25 per cent top up. Tax free interest|
|*All allowances apply to 2020/21 tax year|
As it happens, the Isa was established just six months after Chris Tarrant became a TV sensation with his game show Who wants to be a Millionaire?. While only six contestants in the show’s history have legitimately won the top prize, there are now estimated to be roughly 1,600 Isa millionaires in the UK.
Hargreaves Lansdown, the UK’s largest platform, has 579. While their average age is 71, some are in their 30s. Sarah Coles, personal finance analyst at Hargreaves Lansdown, shares the secret to their success: “Isa millionaires often have core holdings of global funds, which spread the risk across world-leading businesses across the globe. They then go on to specialise with satellite holdings that reflect the level of risk that suits them and their particular interests.”
She adds that the Isa millionaires she’s spoken to say it has been important to have faith and hold on through market fluctuations. “At times of big market movements, they will revisit their portfolio to check it still suits their needs, and whether there are opportunities they want to take advantage of, but they avoid knee-jerk reactions,” Coles says.
On AJ Bell Youinvest, 83 per cent of Isa millionaire money is held in individual equities, and just 14 per cent held in open-ended funds, investment trusts and exchange traded funds (ETFs). On interactive investor, however, investment trusts are the preferred choice, with 54 per cent of Isa millionaire portfolios held in closed-ended funds. It appears there is not an obvious answer as to whether a stockpicking strategy or funds strategy will improve your chances, but the former is more risky.
For those at the start of their investment journey, becoming an Isa millionaire is much more attainable now the allowance is much larger than it was even five years ago, although it could of course be scaled back in any future tax year. If you saved £1,000 a month into your Isa, with market returns compounding at 4 per cent a year, you would have a million pounds in 38 years. That would be made up of £456,000 of what you had paid in, and £580,254 of interest.
At current tax rates, deducting the capital gains tax-free allowance of £12,300, if you are a higher-rate or additional-rate taxpayer the Isa wrapper in this example would provide you with £113,591 in tax savings, assuming all the returns were capital gains.
If part of the returns had come from dividends, your tax saving would be more. Isas can be particularly attractive for high-yielding stocks, as dividend tax is higher than capital gains tax – for now at least.