IC Isa Guide 2022: Toughen up your Isa

So far 2022 has been extremely grim in many respects. The world is gripped by the humanitarian crisis in Ukraine, and plenty of market turbulence has accompanied it. Indices had already been volatile beforehand, with the US stockmarket having its worst January since 2008. UK stocks have offered a rare reprieve, with the FTSE 100 Index down 1 per cent from the beginning of the year to 3 March, compared with a fall of over 10 per cent for the MSCI World Index. But from geopolitical strife to the prospect of inflation, investors have had a great deal to worry about in recent weeks.

If that weren’t enough, the tax environment is about to get tougher, too, with the chancellor so far resisting calls to abort tax rise plans amid surging energy prices. From 6 April, national insurance is due to increase by 1.25 percentage points, lifting the main rate for employees to 13.25 per cent. Importantly for investors, dividend taxes are set to rise by the same amount, with new rates of 8.75 per cent for basic-rate dividend taxpayers, 33.75 per cent for higher rate and 39.35 per cent for additional rate. 

On top of that the pensions Lifetime Allowance is going to become an unwanted reality for more and more investors, with the threshold frozen at £1,073,100 until 2026. All of this means that the judicious allocation of your individual savings account (Isa) – in which you can grow your savings free of tax – is more important than ever.

Confounding compounding

The key to successful Isa accumulation has been documented by the first ever Isa millionaire, Lord Lee of Trafford, author of How to Make a Million – Slowly. He’s also a longstanding FT columnist and the sharp-memoried among you might recall his Isa tips documented in these pages in 2014. Trafford says that patience is the number one prerequisite for successful investing – buying into a growing business and staying with it, reinvesting any dividends.

Remarkably, his Isa hit £1mn as long ago as 2003, which he achieved by investing in companies – not funds. This vindicates the argument that while the risks of investing in individual companies is greater, the rewards can be, too, provided you are prepared to put the research in. 

The UK now boasts more than 2,000 Isa millionaires, according to InvestingReviews.co.uk’s analysis of HMRC data. That’s not bad considering they were only established in 1999, or 1987 if you count Personal Equity Plans which were rolled into Isas. While you can pay in £20,000 to your Isa in the current tax year, a decade ago the allowance was around half as much. 

Regardless of what you invest in, the key to growing your Isa is making contributions every year. Any Isa allowance not paid into the wrapper in a given year is lost – unlike the case for pensions, where you can carry forward unused allowances from the three previous tax years if certain conditions are met. 

The chart below shows that, had you invested £20,000 into the MSCI World index on 31 March every year since 2004, and reinvested your dividends, you’d be a millionaire by now. That’s from total contributions of just £360,000.

Of course, you can’t actually invest directly into the world index, but FactSet data shows the HSBC MSCI World UCITS ETF (HMWO) has actually performed slightly better over the past decade despite its fees. But it only launched in 2010. The chart is for illustrative purposes – the Isa allowances were significantly lower than £20,000 in the wrapper's earlier days and there are plenty of reasons to believe that stock market returns for the next 20 years will not be as strong as they have been over the past couple of decades.   

Different types of Isa

Unfortunately as with most things to do with fiscal policy, the longer Isas have been around the more complex they have become – although for most people’s purposes they are pretty straightforward. The main options are a Cash Isa or a Stocks and Shares Isa (or a combination of the two). Investing in equities rather than cash should give you better returns – particularly with inflation running higher than recent interest rates. 

Lifetime Isas, introduced in April 2017 to replace Help to Buy Isas, provide generous government top-ups for those young enough to open them. You can set one up if you are between the ages of 18 and 40 and pay into it until you are 50. The maximum you can pay in is currently £4,000 a year, although the government will top up your contributions by 25 per cent. 

The inflexibility of Lifetime Isas has invited scrutiny. They are partly designed to help people buy their first home, but you have to pay a 25 per cent penalty if the value of that home is over £450,000 – a very real possibility for London dwellers where the average house price is now almost 50 per cent higher than that. If you don’t use your Lifetime Isa to buy your first home, you cannot access it until you are 60 without paying the 25 per cent charge. Click here for more on Lifetime Isas. 

Innovative Finance Isas (IF Isas) are another option that most investors seem to steer clear of (see chart below), probably wisely. Introduced in 2016 as a tax-efficient way to engage in peer-to-peer lending, consumer website money.co.uk’s best buy list shows target rates on offer ranging from 3 per cent to 9 per cent – but the important thing to note is that these are target rates.  

If you go down the peer-to-peer route, make sure you do a lot of due diligence on where your money is being put to work. Funding Circle, the UK’s only listed peer-to-peer platform, is not currently accepting new sign ups for its Innovative Finance Isa. Investors might take this as a warning. Your money is at risk if the loans default and you would probably have to wait for months to access your money in the case of platform insolvency. 

As we noted in a feature on peer-to-peer lending last year, many prominent peer-to-peer lenders have closed in recent years, notably Octopus Choice last year and Wellesley and Ratesetter in 2020.  

For those with children and grandchildren under the age of 18, Junior Isas are the best way to start them on their journey to compounded riches. The allowance was more than doubled in 2020 to £9,000 per year. 

One thing to be aware of with Junior Isas is that you can’t take the money out until your child turns 18. When they turn 18 it will automatically turn into a normal Isa under their control, so they will be able to do what they like with it. 

Finally, as we wrote about on multiple occasions last year, some platforms offer Flexible Isas, where you can take money out of your Isa and add it back in in any given tax year. This could be a valuable benefit (who knows what the future brings!) but since the government decided to let platforms choose whether or not they offer them, it’s not that surprising that many of the big ones don’t. 

What are Flexible Isas and which platforms offer them? 

Flexible Isas were introduced in April 2016 as a way of giving savers the chance to make the most out of their allowance. The basic concept is that you can move money in and out of an Isa without it counting towards your annual Isa allowance – as long as the money is replaced within the same tax year.

But the problem is that the government didn’t make it mandatory for platforms to offer Flexible Isas. While the majority of the big banks (but not all) have made their cash Isas flexible, the take-up among the big platforms has been lacklustre. 

As you can see from the table in our feature, most of the platforms cite lack of demand as a reason for not offering them. It may also be a commercial decision – why introduce a policy that by its nature could lead to lower fee revenue? Another argument could be that introducing a flexible Isa would be costly to implement, but if that’s the case then a charge could be applied to the customer who uses the facility. 

Ultimately, anyone investing in shares should be thinking in terms of a five-year time horizon or longer. But life happens and for some people a flexible Isa can prove extremely useful – even if you don’t expect it to. If you think Flexible Isas sound like a useful feature but your platform doesn’t offer one, write to their customer service teams and let them know. If enough people do, it could move the dial on “lack of demand”.