Isas: shelter from a tough environment

More than 2,000 UK investors have achieved ‘Isa millionaire’ status – an impressive feat given the tax wrappers were established in 1999, or 1987 if we count the personal equity plans that were later rolled into Isas. But in the past year, a horrendous market sell-off has thinned the herd: Interactive Investor notes that the number of Isa millionaires among its customers came to 852 at the end of January 2023 – a notable drop from 983 a year before.

Unsettling as that might seem, a lurch downward in markets is one of several unpleasant incentives to make as much use of the £20,000 annual Isa allowance as possible. Market falls present good opportunities for bargain hunters with long time horizons, whether they’re seeking total returns or are drawn to juicy yields, and those on the Isa millionaire list will have plenty of experience of market crashes – be it the Covid-19 panic, the financial crisis or even the dotcom bust. Investing as much as possible can pay off richly.

A different challenge that should motivate investors to make the most of both their Isa and pension allowances comes in the form of an increasingly hostile tax regime. The thresholds for the 20 per cent basic rate of income tax (£12,570) and the 40 per cent higher rate (£50,270) remain frozen until April 2028, pulling many individuals into paying larger amounts of tax. The new tax year starting in a couple of weeks will usher in a bigger tax bill for others: the point at which the 45 per cent additional rate of income tax kicks in will fall from £150,000 to £125,140.

On the investment front, the annual capital gains tax exemption will halve from £12,300 to £6,000 on 6 April, only to halve again in April 2024. Meanwhile, the yearly tax-free dividend allowance will also halve, from £2,000 to £1,000, before falling to £500 in April 2024. Within the realms of what is affordable, putting as much money as you can to work within the tax wrappers available is sensible.

Isas have saved investors vast amounts in tax over the years. But even they could fall victim to the shifting sands of policy that have upended pensions and the broader tax landscape at points. This risk was highlighted in a recent Resolution Foundation paper, in which the think tank warned that Isa allowances tended to benefit better-off individuals. It has made the case for capping the amount an individual can have invested in an Isa, at which point they would be unable to add any more into the wrapper. The organisation suggested setting the cap at £100,000.

Such a policy would certainly consign the Isa millionaire to the endangered species list.

Time in the market (not cash)

Calls for a cap on how much can sit in an Isa are new, and unlikely to be acted upon for the time being. A better-rehearsed argument in the sector is that the wrapper should be simplified. Cash Isas and stocks and shares Isas are the best-established vehicles, but the picture is complicated by the additional presence of Lifetime Isas and Innovative Finance Isas. Stocks and shares Isas are the go-to for many investors, and we explore the quirks and relative merits of the other options later on.

But HMRC figures have tended to show that a huge chunk of Isa money sits in cash vehicles – a worrying fact when we consider how corrosive inflation can be over time, and how well investment returns can compound when left to do so. The chart shows that the market value of cash Isas fell back in 2020-21 thanks to a fall in the take-up of this type of account.

The market value of stocks and shares Isas rose – a reflection of the big rise in asset valuations at the time, and arguably the lockdown-inspired rise in interest in investing. The next round of Isa data could well show this trend reversing: stocks and shares vehicles will have suffered on the back of falling valuations, while higher interest rates and a desire for somewhere safe to park savings might drive another uptick in demand for cash.

It’s worth noting that Innovative Finance Isas barely show up on the chart. They had a much smaller £781mn market value in 2020-21, compared with nearly £40bn in stocks and shares Isas.

Risk on or off?

The fact that Interactive Investor Isa millionaires have an average age of 73 demonstrates just how much of a difference time and patience can make to maximising a portfolio’s value. But those investors have also taken a degree of risk: Interactive points out that an Isa millionaire on its platform has, on average, a 42.5 per cent allocation to investment trusts, with 39.9 per cent in equities. This compares with 24.2 per cent in trusts and 37.1 per cent in equities across the platform’s whole Isa cohort.

While this reflects the general preferences of a certain demographic (open-ended funds are more popular among the general cohort, for example), it also shows that risk assets have paid off. Other findings back this theory: the first ever Isa millionaire, Lord Lee of Trafford, gained that accolade by taking the risk of picking stocks rather than favouring the broader diversification available from buying funds. Investors who have been on the wrong side of a risky trade or a poorly diversified portfolio will, however, have a very different experience of the quest to join the ranks of the Isa winners.

Looking beyond shares alone, an exercise carried out by AJ Bell has identified the 50 funds and trusts that would have made you an Isa millionaire by 2023, had you invested the full Isa allowance into one of them on the first day of every tax year, starting in 1999. If we look at the top 10 funds and top 10 trusts the options are pretty varied, although the number of small-cap funds and tech or US equity portfolios, alongside a couple of the private equity investment trusts, is noteworthy.

Not a single tracker makes the list, but that’s in large part because passive funds weren’t widespread in 1999. Passives are certainly likely to be powering some Isa growth in the years to come: AJ Bell recently noted that eight of the most popular 10 funds among its customers in the run-up to the tax year end were passive. In the same period last year, just one passive made the cut.

Lisas: supplementing your retirement

Lifetime Isas (Lisas) are hybrid products that can be used to get a foot on the property ladder or save for retirement. You can open one between the ages of 18 and 39 and contribute up to £4,000 a year until you are 50. Your contributions receive a 25 per cent cash bonus from the government.

As with all Isas, withdrawals are tax free. If you don’t use the money to buy your first home, you need to wait until you turn 60 to access it – any earlier withdrawals will trigger a 25 per cent penalty. Note that, depending on the growth of your investments and how much you withdraw, this can result in you getting back less than you originally paid in. For example, if you contribute £4,000, receive a £1,000 government bonus and then withdraw the whole sum, you only get back £3,750.

All of this makes Lisas quite complicated, and Jon Greer, head of retirement policy at Quilter, dubs them “a Frankenstein’s monster of a product” that tries to address two distinct issues and ends up being inadequate for both. For example, the age of Lisa access is not in line with that of pension access, currently at 55 and set to rise to 57 by 2028, which complicates retirement planning, he says.

But the combination of a government bonus and tax-free withdrawals is still attractive and can make sense in some cases. Alice Haine, personal finance analyst at Bestinvest, says that while they should not be considered as an alternative to regular pension saving, Lisas can be a “useful tool” for those looking to build up an alternative pot of money for their retirement.

Between employer contributions, salary sacrifice options and tax relief, a workplace pension is the most efficient option for the bulk of your retirement savings. Once those allowances are exhausted, for basic-rate taxpayers a Lisa becomes well worth considering for any additional contributions – the 25 per cent cash bonus and 100 per cent tax-free withdrawals generally beat the 20 per cent tax relief and 25 per cent tax-free withdrawals offered by a pension.

Meanwhile, higher-rate taxpayers can claim additional tax relief on pension contributions up to their income tax band, which tends to tip the balance in favour of pensions. But Lisas can still be an option for additional retirement saving, for example if you hit the annual allowance for pension contributions, currently £40,000, but rising to £60,000 as of the new tax year.

While you can draw the bulk of your retirement income from your pension, having some extra funds in an Isa that you can access tax-free can be helpful for additional expenses, and can save you from being pushed into a higher income tax band. A Lisa can be a good way to build up that extra nest egg.

Ifisas: a risky option for the adventurous 

Innovative Finance Isas (Ifisas) are the most niche product of the whole Isa family, and allow you to invest in peer-to-peer (P2P) loans, usually via a P2P or crowdfunding platform. P2P loans typically offer high returns, but are also high risk, so there are quite a few things to keep in mind.

Ifisas are not covered by the Financial Services Compensation Scheme, which normally protects deposits with traditional financial institutions up to £85,000. If borrowers default on their loans or the P2P platform fails, investors may not be able to recover their money.

These are typically fixed-term investments and, depending on demand on secondary markets, it can be difficult to sell them or access the money before the loan ends. Novice investors can only invest 10 per cent of their investable assets into P2P unless they have received regulated financial advice, and a significant amount of research is advisable before taking the plunge.

Ifisas have not proved especially popular so far. The number of Ifisa subscriptions peaked in the 2017-18 tax year at 49,000, but was just 16,000 in the 2020-21 tax year, according to HMRC data. For comparison, the 2020-21 figure stood at almost 3.6mn for stocks and shares Isas.

Bestinvest’s Haine notes that while Ifisas launched in 2016 when P2P lending was growing in popularity, there have been fewer players in the P2P platform space in recent years, narrowing the options.

With their promise of high returns, Ifisas “may appeal to adventurous investors who are willing to take on more risk and benefit from tax-free interest at the same time”, as well as “investors who like the idea of supporting start-ups, entrepreneurs or growing companies in specific fields they are interested in”, such as green projects, she says.

But as Rachael Griffin, tax and financial planning expert at Quilter, notes, with their additional risk and potentially higher fees, Ifisas are “unlikely to be of use to a standard investor”.