ISA: What is it and why is it important?

Now that I am (attempting to) post regularly on LinkedIn (a shameless plug), I've had some follow up questions here and there: what actually is an ISA? What can I put into an ISA? What actually is a Pension? Where should I invest my money? Why are your posts so good?

Admittedly, the last question has been fabricated, however, I have tried to start answering the other questions over the last few months.

So, I thought an article that delves into the above topics would be a good use of time - and is hopefully informative for anyone looking to take control of their finances.

As such, this article will focus on Individual Savings Accounts, otherwise known as an ISA.

What is an ISA?

Think of an ISA simply as a 'box' into which you can put different 'assets' into. The key advantage of this 'box' is that anything inside it will benefit from favourable tax treatment. Essentially, it is a tax-efficient way of saving toward your future, whilst maintaining flexibility should it be required.

There are a few key taxes which are legitimately avoided, dependent on the ISA you select:

Capital Gains Tax - tax on any investment gains. Specifically, this tax is liable when 'disposing of' (selling) an investment. Dependent on what rate of income tax you fall into and the gain itself this can either be 10% or 20%.

Dividend Tax - when a business generates profit there are different avenues in the utilisation of that profit. One such method is to reward shareholders (the people that have bought and now own a piece of that business) by distributing profits to these shareholders. That is what a dividend is. This is subject to tax above a certain threshold, again at different rates dependent on where your income sits - it can be as little as 8.75% or as much as 39.35%.

Savings Income Tax - contrary to belief (at least among friends), interest earned from cash sitting within a bank account or a fixed term deposit account is a source of taxable income and will also be subject to tax at different rates (up to 45%). Once again there are allowances in play in the first instance, dependent on your income.

While there are small allowances for all of the taxes above, putting them into an ISA mitigates the worry of constantly looking to 'dispose' (sell) within allowances each tax year or declaring savings income on your tax return. However, once an ISA and various other investment wrappers are maximised, taking advantage of the above allowances is what a good financial plan should then pivot to incorporate.

How much can I put into an ISA?

When first introduced in 1999, you could put ￡7,000 into an ISA. However, that has now moved to ￡20,000 in this tax year and will remain the same in the 2023/2024 tax year.

How do they work?

Each and every tax year all UK residents have their ISA allowance reset (on the 6th of April). At this point you can put in another ￡20,000 into an ISA if you so wish. You can even split your ISA allowance across the various different types of ISA.

What types of ISA are there?

There are four:

A shout out here for anyone under the age of 18 who wants to invest - there are JISA's available. These are subject to a lower amount of ￡9,000 per tax year at this moment.

Can I have multiple ISAs in the same tax year?

Yes, you can open a different type of ISA in the same tax year.

For example, say you were looking to save for a deposit on a house and wanted to maximise your ￡20,000 ISA allowance. You could put ￡4,000 into a LISA (and benefit from a ￡1,000 bonus i.e. ￡5,000 total into the LISA) and put the remaining ￡16,000 into a Stocks and Shares ISA. You could even split that ￡16,000 in half ￡8,000 into a Stocks and Shares ISA and ￡8,000 into a Cash ISA. In short, you can open multiple ISAs as long as the type of ISA is different and the total does not exceed ￡20,000.

You can't open the same type of ISA in the tax year with multiple providers. For example, if you had invested ￡10,000 into a Stocks and Shares ISA with one provider, you are unable to open up another Stocks and Shares ISA (the same type of ISA) and invest the remaining ￡10,000 allowance with another provider. This would be a breach of the rules. You would be permitted to top up the existing Stocks and Shares ISA to maximise your allowance for the tax year.

You can achieve exposure to lots of different funds with most providers – to this extent using multiple providers to achieve diversification is arguably a bit of a ‘red herring’ and can simply increase complexity down the line when you come to draw on your funds.

How accessible are funds within an ISA?

ISA funds are mostly accessible. Therefore, if you were to need cash immediately you could get your hands on that money fairly quickly. The degree of flexibility is dependent on which ISA (see below) you have selected a Stocks and Shares ISA which as we know can return less than the original amount invested subject to market movements.

This is why it is crucial to hold an emergency fund to cover unexpected expenses and only start investing the surplus funds if you do not expect to need them in the short term.

This is slightly different for a LISA - 'this box' can only be accessed if you are buying your first property or retiring. If you fall foul of these rules - there is a 25% penalty on whatever funds are being withdrawn. This is because you were given a 'top up' by HMRC when putting the money into your LISA.

An ISA and LISA are different to other wrappers like a pension for example, which under current legislation cannot be accessed until you are 55.

Can I still open an ISA if I move abroad?

No. You can't open a new ISA or contribute to an existing ISA if you move away from the UK.

However, any ISA you have contributed to in the UK whilst living here (and therefore qualifying for residency) will still benefit from the favourable tax-treatment ISAs have to offer. Essentially, once you move away you can't add any 'new' assets to an ISA. Local tax rules may differ in this regard. You should seek local advice to assess if the ‘box’ continues to meet your goals and objectives overseas.

The importance of an ISA

Let's run through an example. Scenario: you're motivated and the plan is to invest ￡20,000 for the next five years into a Stocks and Shares ISA. What could your ISA look like after, let's say, 20 years?

Your total invested is ￡100,000. After 20 years this could become ￡241,235 if it achieves an average rate of return of 5% per annum. This is all tax-free. Therefore, on your gain of ￡141,235 you no have any tax payable, which would not be the case if it were held in a general investment account!

So, if you were to have invested this outside an ISA and rather in a 'general investment account' with no favourable tax treatment, you could potentially pay a tax charge of ￡27,647. This is the power of an ISA.

Usual caveat - market returns never follow a linear 5% p.a. return year-on-year return, this is merely an illustration of what could happen after 20 years.

Of course, as mentioned these are assumptions. If you were to need the money in the short term to cover expenses and withdraw funds or performance isn't as robust as 5% p.a. or the tax regime on ISAs change then this will impact the above example. The diagram is more for illustrative purposes to show what an ISA could potentially offer.

Summary

An ISA is a great first step towards saving for your future and can be used to meet many different financial goals that you may have.