Six people who should be using an ISA

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Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.

ISA use has rebounded recently, after the accounts fell out of favour when the Personal Savings Allowance was launched in 2016. After that tax break was brought in, ISA use dropped by 13% in a year. However, in the latest figures available*, for 2019/20, the number of ISA accounts opened has finally rebounded to above pre-2016 levels: a total of 13m ISA accounts were opened in the year.

However, ISAs are still underused, with the amount subscribed to them remaining below pre-2016 levels. In 2015-16 a total of £80bn was put into ISAs and the latest figures show that £75bn was paid in*. And that’s despite a soaring ISA allowance, which jumped to £20,000 in 2017/18.

The Personal Savings Allowance is still sufficient for many people to save and be protected from tax. It means basic-rate taxpayers can earn £1,000 in savings interest before they have to pay tax, while higher rate payer can earn £500 before tax is due. That means if their savings are in cash and earning interest of 0.5% a basic-rate taxpayer could have £200,000 in savings and still be covered by the allowance, while a higher rate payer could have £100,000 before tax was due.

However, there are six key groups of people who would definitely benefit from using an ISA – from those due a payrise to people saving for their first property. These people face either higher tax bills or a hit to their savings potential (or both) if they shun ISAs.

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1. The First-Time Buyers

For those planning to buy their first home, using an ISA can get them free Government money. With a Lifetime ISA you get a 25% Government bonus on the money you pay into the account, which will then go towards your first home – a rate of return that’s hard to beat.

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You can pay in up to £4,000 a year into a Lifetime ISA and get a maximum Government bonus of £1,000 each year, which could super charge your deposit savings pot. Someone planning to buy in five years’, for example, could get an extra £5,000 for their savings. But anyone considering it should watch out for a couple of things: it only works if you have at least 12 months until you plan to buy a house, otherwise it’s a no-go. And you have to be sure you’re ok locking the money away for a deposit, as if you withdraw the money for anything other than a first home or at the age of 60 you’ll pay a 25% exit fee.

2. The Payrise Seekers

Anyone who is moving job or getting a payrise and thinks they might move into the next tax bracket needs to watch out, as they will see their Personal Savings Allowance cut or even disappear altogether. Someone on the cusp of earning more than the basic-rate band, so currently £50,270, will see their Savings Allowance slashed by £500, meaning only their first £500 of savings income will be tax free. If someone is poised to move into the additional-rate bracket, so earning over £150,000, they will lose the allowance entirely, meaning all their non-ISA savings interest will be taxed at 45%.

For example, if you change from the basic to higher-rate tax band you’ll face a £200 tax bill on that £500 of savings interest that’s no longer protected by the allowance. And if you move from the higher to the additional rate band you’ll face a tax bill rise of £225. If you’re close to these tax bands it could be a good idea to move some of your money into an ISA, and reduce your future tax bill.

3. The Income Investors

Investors taking dividends from their investments will be faced with an even higher tax bill from April, as the new Health and Social Care Levy adds an extra 1.25 percentage points onto dividend tax rates. It’s the latest increase, with recent years seeing successive changes to the dividend tax allowance raising bills.

Now you can earn just £2,000 in dividends before you start to pay tax, and from April that will be at 8.75% for basic-rate taxpayers, 33.75% for a higher-rate taxpayer or 39.35% for additional-rate taxpayers. The £2,000 allowance means that someone with more than £50,000 of investments outside an ISA earning a 4% yield will hit the limit. If you moved this money into an ISA then it will be free of income tax. For an investor taking £10,000 in dividends in a year, that could see their tax bill cut by £3,148**.

4. The Future Income Withdrawers

People who plan to take an income from their savings in future years need to be mindful of how this is taxed, if the money sits outside an ISA or pension. Any withdrawals from ISAs are free of tax, meaning you can draw an entirely tax-free income off the investment pot. Someone with £200,000 in an ISA, earning a 4% yield, can take a £8,000 income tax free each year, while someone with a £600,000 ISA will be able to take £24,000 income tax free – at this level you’ll save £2,300 each year in tax, assuming you have no other income. If you take this same income over 20 years, for example, that’s a total of £46,000 saved in income tax.

5. The Supersized Gains Investors

Another group who need to be worried about their tax bills are those who have seen their non-ISA investments perform very well or who have held the assets for a long time and have seen them gradually rise – either way they will be sitting on some hefty capital gains. Any investments outside of an ISA will incur capital gains tax of 10% or 20% on any gains above the tax-free allowance, depending on the income tax bracket. You can make use of your capital gains tax allowance each year to bank some gains and move them inside an ISA.

So-called ‘Bed and ISA’ means you can sell assets with gains of up to £12,300 (assuming it won’t breach your remaining ISA allowance) and then buy them back within an ISA, without facing any tax. This means your future gains on those investments will then be protected from capital gains tax too. You can do a similar move called ‘Bed and Spouse and ISA’ where you transfer the assets to your spouse instead, who uses their capital gains tax allowance and ISA allowance, and puts it in their ISA.

More about Bed and ISA

6. The Big Hitters

If you’ve managed to build up a sizeable savings or investment pot outside of your ISA you’ll be pretty pleased. But a word of warning: the larger your non-ISA savings the longer it will take to move it into an ISA. The ISA allowance is now a very generous £20,000 per year, but if your pot is much larger than this it could take a number of years to move it into the tax-efficient ISA.

Savers with large non-ISA funds are at the mercy of future Governments changing the tax rules on savings, scrapping the personal savings allowance or even reducing the annual amount you can save into an ISA. People were caught out by this before with the cut to the dividend tax allowance and many were hit with a large tax bill. If it will take several years’ worth of allowances to move your money into an ISA, think about starting before the end of this tax year.

*Based on the latest HMRC ISA data.
**Based on the individual being an additional rate taxpayer.

How you're taxed will depend on your circumstances, and tax rules can change. LISA rules apply. Remember that the value of investments can change, and you could lose money as well as make it. Past performance is not a guide to future performance.

These articles are for information purposes only and are not a personal recommendation or advice.


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Written by:
Laura Suter

Laura Suter is head of personal finance at AJ Bell. She is a multi-award winning former financial journalist, having specialised in investments. Laura joined AJ Bell from the Daily Telegraph, where she was investment editor. She has previously worked for adviser publications Money Marketing and Money Management, and has worked for an investment publication in New York. She has a degree in Journalism Studies from University of Sheffield.