How to save and invest without losing to the taxman
Thursday 27 Feb 2020 Author: Daniel Coatsworth

ISAs are one of the greatest inventions in the world of saving and investing. The ability to hold your money in a wrapper that is free of tax on capital gains and dividends is a wonderful thing and everyone should make the most of them each year.

There are six types of ISAs which is arguably too many. We would welcome ISA simplification by reducing the number on offer. Until that happens, it is worth understanding how each type of ISA differs from the rest and how they are best used.

In this article we look at five of the six ISAs in detail, how much you can put into them each year, and suggest a few investment products that might suit people in certain situations. We’ve ignored the Help to Buy ISA for this article because it is no longer open to new applications and is a cash-only product that’s fairly simply to understand.


HOW TO USE A LIFETIME ISA

Aunt Mabel, 39, and her niece Maggie, 18, have heard about the Lifetime ISA and want to take advantage of the free Government money it offers so they can meet their savings goals.

With one eye on retirement, Mabel wants to enhance her savings while Maggie wants to buy her own flat in three years’ time when an inheritance is paid out on her 21st birthday.

They plan to use the Lifetime ISA, which can be opened by people aged between 18 and 39.

You can put up to £4,000 a year into a Lifetime ISA until you turn 50, with the Government adding a 25% bonus to your savings up to a maximum of £1,000 a year. You can put the money into either a Cash Lifetime ISA or Stocks and Shares Lifetime ISA.

A saver who puts £4,000 every year into a Lifetime ISA from the age of 18 until they are 50 will get a total bonus of £32,000 from the Government, before any interest or growth.

For Maggie, her inheritance alone won’t be enough for a deposit on a flat but she could get there by using the Lifetime ISA to save. However, as she only has a three year goal to save Maggie is best off avoiding the stock market and putting the money in a Cash ISA instead of a stocks and shares one, so she can take advantage of the 25% bonus while safe in the knowledge her savings pot
won’t go down.

A stock market cycle typically lasts around five years, so three years may not be enough time to recover from any bad periods in the stock market.

Because Mabel has a much longer timeframe she has more options available. Anyone using a Lifetime ISA can only withdraw their money without incurring a 25% charge if buying their first home, aged 60 or over, or are terminally ill with less than 12 months to live.

Mabel still has a mortgage and bills to pay, so can only afford to invest a small amount of her monthly income.

A good way for Mabel to get started would be drip-feed investing, where she puts small amounts of money into a Lifetime ISA every month.

Given her long timeframe, she can afford to take a few more risks so may want to invest entirely in shares now and potentially add
some bond exposure in 10 years’ time.

A cheap tracker fund providing very broad exposure to companies around the world might suit such as SPDR MSCI World ETF (SWLD) which has a very low annual charge of 0.12%. It’s an ideal product for regular investing every month, particularly for individuals who don’t have the time or inclination to monitor the markets all the time.


HOW TO USE A JUNIOR ISA

Graham and Poppy are both 35 years old and want to start saving for their newborn child David. Since they have 18 years to make the money work for their new arrival, they plan to invest regularly into a Junior ISA, as well as topping the account up with any birthday and Christmas money that comes in. They are happy to take some risk as time is on their side.

Parents or guardians with parental responsibility can open a Junior ISA and manage the account, but the money belongs to the child. Up to £4,368 can be paid in each year. The child can take control of the account when they’re 16, but cannot withdraw the money until they turn 18.

Proud parents Graham and Poppy can either choose a Cash Junior ISA or a Stocks and Shares Junior ISA. A lot of people opt for Cash Junior ISAs, which are essentially tax-efficient savings accounts, because they are often worried that shares can rise and fall in value over the short term. Yet history tells us that shares provide a greater return than cash over the long run.

For Graham and Poppy, a tax-efficient Stocks and Shares Junior ISA is well worth considering for David. Grandparents, other family members and even friends can pay into the Junior ISA as well.

Graham and Poppy lead busy lives and aren’t especially confident about selecting individual shares for the Junior ISA and would prefer to let a fund manager do all the hard work, even though that means paying a small ongoing charge. They like the idea of using a fund manager in the belief that this individual could beat the market. They want to make as much money as possible for David and are happy to research a range of actively-managed funds.

One product they should consider is Polar Capital Technology Trust (PCT). Fund manager Ben Rogoff has a great track record of identifying opportunities in the tech space and this sector has the potential to deliver turbocharged returns for David. Graham and Poppy should understand that investing in the tech space can be quite volatile and so there could be times when the shares are experiencing wild swings.


HOW TO USE A CASH ISA

Mary is a 40-year-old single mother of two (aged 13 and 17) working in the purchasing department of a building firm. She has cash savings of about £13,000 from the sale of a holiday home and is thinking about putting the lump sum into a Cash ISA for back-up savings or potentially university costs given her eldest isn’t that far
away from doing a degree course, although they are still uncertain about wanting to go.

She already has a separate pot of cash set aside for emergencies like a broken boiler or things going wrong with her car. Mary also has an investment ISA through which she invests in various tracker funds and ETFs to bolster her retirement savings.

Mary is willing to tie up the £13,000 cash for one year through a fixed-rate deal but is reluctant to lock the money away for too long in case interest rates begin to rise and she loses out.

A Cash ISA would be attractive for Mary for the simple reason that she will never have to pay tax on the income generated by her savings in that wrapper. Up to £20,000 can be deposited in a Cash ISA each year.

Rates will be low for either a fixed-rate savings account or a Cash ISA. At the moment the best she could get is 1.65% for a one-year fixed savings account from Atom Bank, 1.31% for an easy-access Cash ISA from Virgin Money, or 1.41% for a one-year fixed Cash ISA from OakNorth Bank.

So £13,000 into the Atom Bank account would generate £214.50 interest before tax or £183.30 interest tax-free from the OakNorth account.

There is barely any difference between the returns from two accounts which is a sad reflection of how hard it is to make a decent return on cash at present.

Mary might be better off reassessing her situation in a year’s time to decide exactly what she wants to do with the money. If her child goes to university then clearly she is well placed to be able to help pay for it. Yet if they don’t want to continue studying it might be worth investing some of the £13,000 pot in the market in the hope of making a much better return over time. In such circumstances, Mary must understand the extra risks involved of investing and accept that the value of her cash pot could fall if investments don’t work in her favour.

She’s fortunate to already have some emergency savings – anyone not in that situation should certainly consider putting cash to one
side before investing.


HOW TO USE AN INNOVATIVE FINANCE ISA

Adam is in his mid-thirties and has accumulated some spare cash through prudent spending and regular saving. He has heard of peer-to-peer lending and wants to find out if the Innovative Finance ISA is something he should consider.

Up to £20,000 a year can be put into this form of ISA which is used for holding peer-to-peer lending investments.

The seductive idea for peer-to-peer lending is that by cutting out the big banks you can potentially earn a higher rate of interest than a traditional bank account or Cash ISA.

A peer-to-peer lending platform will take applications from borrowers and perform credit checks, rejecting around 80% of them. If successful, Adam’s money would be parcelled into small units and lent out to a broad spectrum of borrowers, so that the maximum exposure to any one borrower is low, usually around 1%. Money can be lent to businesses as well as individuals.

Should any investment go sour, Adam stands to lose his whole investment minus any amounts recovered. In return for taking the risk, he might earn 3.5% to 6%, or potentially more. The platform provider’s fees, usually around 1%, are included in the projected return.

Actual returns can differ from ‘headline’ projected returns that you might see on the marketing literature.

Adam should expect to lock his money away for at least three years and there are no guarantees for returning all of his money back.

It is worth pointing out that, unlike Cash ISAs, money in an Innovative Finance ISA is not protected by the Financial Services Compensation Scheme whereby up to £85,000 is guaranteed by the Government in the case of bankruptcy. Peer-to-peer lending is an investment, not a savings scheme.

In addition, again unlike Cash ISAs, access to money is not immediate and it could take a long time to get cash back.

Adam would need to be aware of the heightened risks with this part of the market. Last year’s collapse of peer-to-peer lender Lendy demonstrates the risks involved which left thousands of investors facing losses of close to half of the £152m they invested.

In addition projected returns are not a guarantee and it’s very possible that the actual yield that Adam receives will fall short of his expectations, because the assumed default rate is underestimated.

Think about it this way, if junk bond (very high risk) yields are around 3% and you are offered the prospect of earning 5% or 6%, the peer-to-peer investment probably involves taking considerable risk.


HOW TO USE A STOCKS AND SHARES ISA

Richard, 52, is married to Alison, 45, and works as a factory supervisor. He has been over-paying his mortgage for several years as he understands that paying off his debt early can save him money in the long run.

With interest rates likely to stay low for some time, Richard now wants to reduce his mortgage payments and increase contributions to his ISA to maximise his full allowance.

Richard hopes to retire at age 60, which gives him eight years to build up his pot so that he can make the most of tax-free withdrawals from the ISA in the early stages of retirement before dipping into his actual pension.

He has a medium appetite for risk and wants to accumulate as much capital as possible, which is why he opted for a Stocks and Shares ISA instead of a Cash ISA.

ISA allowances have grown in recent years and now every adult has a £20,000 annual limit for a Stocks and Shares ISA. Richard could encourage Alison to make the most of her allowance as well so they both maximise the benefits of ISAs to the combined tune of £40,000 each year for the next eight years, subject to them earning enough money.

As Richard wants his capital to build up and doesn’t want to take any dividends, if he buys an open-ended fund he should make sure he chooses the ‘accumulation’ version so that his dividends are automatically reinvested. Look for the letters ‘acc’ in the product name to find the accumulation version. Thanks to compounding, his reinvested dividends will give his existing capital an extra boost each year.

If Richard opts for shares or investment trusts, he should tick the box on his provider’s platform allowing him to automatically reinvest any dividends. In most cases investors have to ‘opt in’ to choose to reinvest their dividends.

When choosing a trust or a fund it’s important to look at ongoing charges. A fund with high fees will eat into Richard’s returns a lot quicker than one with low charges.

Spreading investments across countries is a good strategy for the long term, so Richard should think about including a global fund in his selection to diversify his risk. A good choice is Baillie Gifford Global Alpha (B61DJ02) which has an ongoing cost of 0.6% and has investments around the world, half of which are listed on a US stock exchange. Key holdings include retail group Amazon, payments network MasterCard, health insurance provider Anthem and media group Naspers. 

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