Opportunity Knocks

Since the 6 April 2010, everybody is able to put aside £10,200 into an ISA. This means a couple now have access to the equivalent of nearly three times the previous maximum ISA allowance.

Given the uncertainty with the UK economy and the possibility of rising taxes in the coming years, the opportunity to put savings out of the Chancellor’s reach is one that shouldn’t be missed. Of course, nothing is set in stone when it comes to tax, but it would take something extraordinary for a Government to risk making significant changes to ISAs, as the political fallout could be dramatic.

The Tax Advantages

These are unquestionable for higher-rate taxpayers – particularly as an ISA means they don’t have to pay tax at 22.5% on dividends. In fact, ISA’s are one of the few benefits higher-rate taxpayers still receive. Furthermore, everyone can benefit from the tax situation on interest-paying investments – though investors sometimes need reminding that this applies to bond investments as well as cash ISA’s.

Generating a tax-efficient income – which would normally be taxed at either 20% or 40% – is particularly useful in retirement, but risk-averse investors of all ages may be interested to know that an ISA can contribute to steady long-term growth when the payments are reinvested.

Capital gains tax is slightly more complicated, as it can be argued that few investors will be in a position to use this benefit. However, there will be those who have significant sums to invest and want to take an aggressive investment approach. You can use other ways to mitigate a CGT liability, but the advantage of ISA’s is that you will have full access to your money at all times, without having to worry about managing a potential tax burden.

For higher-rate taxpayers, and anyone who is self-employed, ISA’s can also be appealing because they do not need to be declared on a tax return. If you have a complex income portfolio could find this particularly useful.

Not just for good times

Although many people use ISA’s to save for particular goals, these savings schemes are also a good way to build up money for a rainy day. The economic troubles of the last few years have shown us all that redundancy is never far away when times are bad – and even people in well-paid positions are not immune to an extended period when they are not working or have to take a job on a lower salary.

In these circumstances, ISA’s have another benefit – because they are not declared on a tax return, the income they pay is not counted in the calculations for Working Tax Credits or Child Tax Credits. As a result, they could help boost your income when times are tough.

The retirement angle

A similar situation occurs in retirement. Once your taxable income is above £22,900, you lose £1 of additional age-related allowance for every £2 you earn, which is an effective tax rate of 30%. However, ISA income is not included in these calculations, so a retired person receiving income from bond investments in their ISA could potentially avoid a taxable situation twice – and save a significant sum.

ISA’s are just one part of effective financial planning and they are often used best when they are combined with pensions.

Here’s an example:

An investor saves £5,000 in a pension every year for two decades. They receive basic-rate tax relief for 15 years and higher-rate relief for the last five. Based on the past performance of the FTSE All-Share index, they would have a lump sum of just under £400,000.

If they put their money into the same funds within an ISA for the first 15 years and then moved it gradually across into the pension once they started paying higher-rate tax, their pot would be worth over £500,000 – an increase of £100,000, without saving anything extra.

Once they have retired, they could then take the tax-free lump sum from their pension and drip feed it into an ISA. This could produce a tax-efficient income and they will also have the comfort of knowing it can be left to their family in their will.

One final point in favour of ISAs that is much more straightforward. There is no additional cost or penalty for holding funds inside an ISA, rather than outside, so why not take advantage of the benefits? As long as you plan to invest the money anyway, there really is nothing to lose from choosing an ISA.