Don't overlook the flexible benefits of Isas

The attraction of pensions has increased following rule changes in 2015 that allow more investors to draw from them in retirement, rather than trade them in for an annuity, and pass them on after they die. This has resulted in many investors opting for pensions instead of Isas, and over the past six years the number of new Isas being opened has fallen, according to broker AJ Bell. The Investment Association, the trade body that represents asset managers, reports that 10 years ago investors preferred to hold investments in Isas. But in 2018 investors put more than five times the amount into pensions that they put into Isas (see chart 1).

However, there are several stages in life where an Isa can be a better option than other investment products such as self-invested personal pensions (Sipps) or trading accounts. Laura Suter, personal finance analyst at AJ Bell, says many people forget to use an Isa because they are not aware of the tax benefits, or don't think it suits their current circumstances.

“But people’s circumstances can change as they accumulate wealth and tax rules can change, resulting in tax breaks being withdrawn by the government," she adds. "However, once money is inside an Isa it is protected from tax forever, even if that tax advantage is not felt by the investor immediately.”

Another issue is investors wasting their Isa allowance on cash Isas. It makes more sense to shelter higher-returning investments that incur more tax, such as shares and funds, in Isas. Savers also benefit from the personal savings allowance, which allows basic-rate taxpayers to earn up to £1,000 a year in interest on cash tax-free, and higher-rate taxpayers £500 tax-free.

Jackie Beard, director of manager research services at data company Morningstar, says: “The fund industry has created ever more ways to tempt investors, but it hasn’t really caught their interest in a significant way. So cash Isas are still the preferred choice for the majority. We have a long way to go to convince people of the merits of investing through an Isa, which include tax-free savings, the ability to contribute monthly and compounding returns, which help to grow portfolios.”

Who should use an Isa?

Ms Suter says various types of people would benefit from using an Isa. These include investors who are taking income from their portfolio or plan to in future. Dividends from shares or funds outside tax wrappers such as Isas and Sipps are subject to dividend tax. Cuts to the value of dividends you can receive tax-free mean the dividend tax allowance is now just £2,000. So, for example, a portfolio worth £51,000 with a yield of 4 per cent could incur dividend tax.

Dividend tax rates

Source: GOV.UK

And withdrawals from a Sipp are taxed at your marginal rate of income tax, after you have taken your 25 per cent tax-free entitlement.

But withdrawals from an Isa are entirely tax-free. “It’s important for people to plan whether they’re going to take an income from their Isa savings," says Ms Suter. "You can draw a tax-free income from an Isa. So, for example, an investor with £200,000 in an Isa that earns a 4 per cent yield could take an £8,000 income tax-free each year. And an investor with a £600,000 Isa could take £24,000 income tax-free, saving £2,430 each year in tax. If they took this annual level of income for 20 years, they would save £48,600 in income tax.”

Isas also shield returns from capital gains tax (CGT), which can be helpful for investors with large portfolios. Ms Suter says: “Someone who has held investments outside an Isa for a long time, or whose investments have performed particularly well, may have made large capital gains with their investments. They will pay 10 or 20 per cent tax on any gains above the annual CGT allowance [£11,700 for the 2018-19 tax year]. But you can use your CGT allowance each year to bank some gains and move them inside an Isa.”

If investors have investments outside a tax wrapper which have made substantial gains, each tax year they could sell investments with gains worth up to £11,700 and buy them back inside their Isa without facing any tax charge. This is known as a 'bed and Isa'.

There are also Isas that allow investors to save for a specific aim. Lifetime Isas and Help to Buy Isas are for long-term investing or saving up a deposit to buy a first home. The government gives qualifying investors a 25 per cent top-up on what they save into these Isas, within annual limits. And because you can use the savings in a Lifetime Isa for a house deposit and retirement savings, it means younger savers don't have to decide between investing or saving for a house.

“The Lifetime Isa has a higher annual contribution limit [than Help To Buy Isas] of £4,000 and a higher annual government bonus of up to £1,000 each year," explains Ms Suter. "But this only works if you have at least 12 months until you plan to buy a house [because you can't use the balance in a Lifetime Isa to buy a home for 12 months after opening it]. If you plan to buy in the next 12 months you should use a Help to Buy Isa, which you can pay £200 a month into, as well as £1,200 in your first month – getting your 25 per cent government bonus on top.”

But if you want and are eligible for a Help to Buy Isa you should think about opening one soon because these will not be available after 30 November 2019.  

Flexible benefits

There are fewer restrictions on withdrawals from stocks-and-shares, cash and Innovative Finance Isas than pensions. You can withdraw from them when you want, but you cannot access pensions until you are age 55. This means that with an Isa you can both invest tax-efficiently for retirement and withdraw funds for shorter-term financial goals such as a child’s education, if necessary.

However, you do not get government tax relief at your marginal rate on Isa contributions. So while investments can grow free of tax in both Isas and pensions, your pension investments receive an extra boost from up-front tax relief – especially if you’re a 40 or 45 per cent income taxpayer.

“If you are planning to save or invest for the long term, the up-front tax relief will always make a pension more attractive, and you can maintain the same flexibility of choice on where you invest,” says Adrian Lowcock, head of personal investing at platform Willis Owen.

According to wealth manager Bestinvest, if you invest £10,000 into an Isa that grows at 6 per cent a year, after 20 years this would be worth £32,071. However, £10,000 saved into a pension by a basic-rate taxpayer would be topped up with £2,500 government tax relief, and if invested in the same way would be worth £40,089 over 20 years. Savers can also use salary sacrifice when investing in a workplace pension, and reduce their overall income tax bill. A £10,000 gross investment into a pension only costs £6,000 if you pay 40 per cent income tax and £5,500 if you pay 45 per cent income tax.

Jason Hollands, managing director at Bestinvest, adds: “There is no guarantee that such generous features will be available in future so they should be used while they are available.”

The annual Isa allowance cannot be carried forward, meaning any that you do not use by the end of the tax year is lost. But unused pension allowances from the previous three years can be used, subject to certain rules.

However, Mr Hollands adds: “Even though pensions have become much more flexible since the rules were reformed in 2015, the earliest age at which a pension can be touched is 55. And although you can cash a pension in completely, the amount that can be taken as a tax-free lump sum is restricted to 25 per cent. Anything above this is subject to income tax."