ISA Essentials: Why it pays to use your allowance

Since its launch in 1999, the Individual Savings Account (ISA) has offered British investors a tax-free haven for their savings. Introduced by then-chancellor Gordon Brown, the ISA has saved investors tens of billions in capital gains and income tax. Indeed, this year alone, the tax wrapper is expected to save Britons over £7bn.

But by helping savers, the ISA has started to become a headache for the government. As public sector spending requirements continue to mount, the chancellor is seeking new ways to fill the public purse. Tax allowances and wrappers are an obvious place to look.

And so in last year’s Autumn Statement Jeremy Hunt announced a substantial decrease in the tax-free allowance for capital gains and dividends, making the ISA wrapper an even more important perk for Britain’s investors.

This article aims to help you take advantage of your ISA allowance in the current tax year and beyond. You will learn:

• The answers to 10 frequently-asked questions about ISAs

• How much ISAs can save you if you use them effectively

• Why tax changes are making ISAs more important than ever

10 need-to-knows

1. What is an ISA?

An ISA is a tax-free savings account. Money saved within the ISA wrapper isn’t charged any income, capital gains, or dividend tax.

2. How much can I save in my ISA each year

All eligible ISA participants receive a £20,000 annual allowance. This renews at the end of each tax year on 5 April. You can’t roll your ISA allowance over into a new tax year. Use it, or lose it.

3. Is there a maximum amount I can save in my ISA

For now, there is no upper limit for how much you can save in an ISA. The only restriction is your £20,000 annual allowance.

4. What are the different types of ISA?

As of February 2023, there are five different types of ISA available in the UK.

Far and away the most popular ISA is the Cash ISA - a basic account where your savings will earn interest.

Stocks and Shares ISAs - the core focus of this article - allow you to hold a wide range of assets including investment funds, such as unit trusts, open-ended investment companies, investment trusts and exchange traded funds. You can also invest directly in equities in both domestic and international markets.

You have to be 18 to open a stocks and shares ISA, but anyone over the age of 16 can open a cash ISA.

More experienced investors might be tempted by the Innovative Finance ISA, which is designed to act as a vehicle for peer-to-peer lending. The £20,000 annual ISA allowance includes any savings in an innovative finance account.

The Lifetime ISA was introduced in the UK in 2017 to replace the help-to-buy ISA. The money saved in one of these accounts must be used either to buy a first home, or for a pension. Lifetime ISAs can be either cash or share accounts, but the real benefit comes from the 25% bonus contribution from the government. Unlike the Innovative Finance ISA, Lifetime ISAs have their own annual allowance of £4,000, but this does eat into your total £20,000 ISA allowance. And beware, there is a fine for withdrawing the money to spend on anything other than a house purchase or pension.

And finally, there is the Junior ISA which parents can set up on behalf of their children under the age of 18 and save up to £9,000 a year in either cash or stocks. Between the ages of 16 and 18, Junior ISA owners can manage their own savings, but they can’t withdraw any money until the age of 18, at which point the account will automatically transfer to an adult ISA.

5. Can I have more than one ISA?

You can hold several ISA accounts at one time, but you can only open or pay into one of each type of account in a single year. For example, if you have both a cash and a stocks and shares ISA, you can save £10,000 in each in the same tax year. But if you have two stocks and shares accounts you can only pay into one in each tax year. That means it is especially important to choose your ISA provider carefully - you don’t want to face restrictions and then be unable to pay into a different account.

6. Does my allowance change if I have more than one ISA?

Your £20,000 annual allowance can be split across stocks and shares, cash or innovative finance ISAs. But remember to keep an eye on your usage - no matter how many accounts you have, you still only have an annual allowance of £20,000. If you have just one account, the provider will probably keep an eye on your savings for you and restrict you from adding more than £20,000 in a single year. But if you have multiple accounts with different providers it’s up to you to monitor your savings. If you go over the maximum, HMRC is likely to get in touch to correct your mistake.

The allowance for the Junior ISA falls outside of your £20,000 allowance so you can save a further £9,000 on behalf of your child in their account.

7. If I transfer my ISA to a new provider, does that eat into my allowance?

There are a few reasons why you might want to switch their ISA provider. Perhaps you have found better fees elsewhere, or maybe you have several accounts which you are looking to consolidate into one. For anyone looking to switch providers it is important to use the transfer tool. This keeps your money within the ISA wrapper. If you withdraw money from an existing ISA account to your bank account and then move the funds into a new ISA, you will eat away at your annual allowance.

8. What is a Flexible ISA?

In 2016, the government introduced the Flexible ISA. This allows savers to withdraw any amount of money from their ISA and reupload it in the same tax year without it eating into their allowance. For example, if you had a £100,000 ISA and wanted to withdraw £40,000 for a large one-off payment, you could redeposit the same amount of money later in the tax year and still have your £20,000 allowance.

Most big banks offer flexible accounts on their cash ISAs, but very few of the investment platforms and brokers do. So if you want a flexible ISA for your stocks and shares account, you’ll have to choose your broker carefully - IG, Charles Stanley and Barclays Smart Investor are a handful of examples of brokers which currently offer flexible Stocks and Shares ISAs.

For non-flexible ISAs, your allowance stays at £20,000 a year regardless of how much you withdraw. For example, if you use your £20,000 allowance in the first month of the tax year and then withdraw £10,000, you won't be able to put the money back in.

9. Should I use a Stocks and Shares ISA or a Sipp?

The number of ISA accounts has been falling in the UK in recent years and as of February 2023, there are about 12m accounts in total. That’s about 18% of the UK population. But only 4m of those are stocks and shares ISAs, or just 6% of the population.

A Sipp (Self Invested Personal Pension) has become an increasingly popular account in recent years. Just like the ISA, the Sipp provides a wrapper which shelters your investments from capital gains and dividend tax. You will also get an income tax refund on any contribution you make to your account. For example, if you put £800 into your Sipp every month, the government will contribute £200 (20%) or more if you are a higher rate tax payer.

The key differences between the ISA and Sipp tax wrappers are laid out in the table below:

A big question which faces UK investors is whether they should use their Sipp or ISA allowance first. And the answer really depends on when you want to spend the money.

If you know the money you are saving is for retirement, the Sipp offers a more generous wrapper as your investments will receive a 20% bump from the government, which will subsequently benefit from compounding. For example, an investor who saves £8,000 in their ISA every year, which grows at an annual rate of 4%, will be left with a portfolio worth £230,225 after 20 years. A total profit of £70,225. The same investment in a Sipp by a basic-rate taxpayer will have tax added back, meaning £10,000 is invested every year. After 20 years the portfolio would be worth £287,781 - a total profit of £127,781.

If you are unsure when you will need the money, the ISA is a better option as there are no restrictions on when you can take the money out. Plus, all of the money saved in an ISA is free of capital gains, income and dividend tax at the point of sale. By contrast, when you withdraw the money from your Sipp only 25% can be taken as a tax free lump sum. Income withdrawn thereafter is subject to income tax.

10. Should I use my ISA allowance in a weak market?

Even if the prevailing market conditions are off-putting, you should still use as much of your ISA allowance as you can afford. You can add money to your ISA account and then leave it in cash until you’re ready to invest in stocks.

Many stocks and shares accounts offer interest on your cash savings. Indeed, Moneyfarm currently offers the best rate of return on cash in any type of ISA account with an interest rate of 3.25%.

Once the money is in the ISA wrapper you can use it to invest whenever you want. And remember, if you don’t use your allowance this year, it’s gone.

Why it pays to take advantage of your ISA allowance

The benefits of the ISA wrapper are unique to each individual as they are determined by your personal financial circumstances. The table below provides a quick refresher of the personal allowance and tax rates for investors in the 2022/23 financial year (these are set to change, more on that below):

At its most basic, an ISA can save you on your tax bill, ensuring taxes don’t eat away at your hard-won returns. The chart below shows the capital gain for an investor who invested their maximum ISA allowance in an S&P 500 tracker fund every year between April 2010 and April 2019 and then decided to bank their gains at the end of the 2019/20 tax year just as the Covid-19 pandemic took hold.

If the example above was all contained within an ISA, the investor would have to pay nothing for the capital gains accumulated in the period. Outside of an ISA, their tax bill would be £9,373 or £18,474 (depending on their tax bracket).

And talking of tax brackets, the ISA wrapper can also stop savers and investors from slipping into a higher bracket. It is important to note that dividend and interest income is added to an individual’s earned income even if it is below the personal allowance. So, even if you don’t have to pay dividend or income tax on the returns themselves, they can contribute to your tax bill by sending you up into a higher tax bracket.

Why the ISA is set to become an even more important

In the coming years, the ISA wrapper will be even more important to investors as their personal allowances on capital gains and dividends are sharply reduced by the government.

In the 2022/23 tax year the personal allowance is £12,300 for capital gains and £2,000 for dividends, but that is set to be cut in half to £6,000 and £1,000 in the 2023/24 tax year and then be halved again to £3,000 and £500 in the following year.

This so-called ‘stealth tax’ is set to land savers with much higher tax bills on investments outside of their ISA in the next few years. The charts below show the hypothetical tax bills for investors who earn £12,300 in capital gains and £2,000 in dividend income (the current personal allowance) in each of the next three tax years.

So with the ISA wrapper set to become even more beneficial to the UK’s investors, make sure you make the most of your allowance.