Individual Savings Accounts (ISAs)
ISAs are useful tax-saving wrappers. Using them to their best involves some surprisingly difficult decisions.
We hope you are clear that an ISA is a wrapper, not an investment. You cannot "invest in an ISA", no matter what the advertisements say. You can only invest in X, Y or Z. Then, you can chose to hold X,Y or Z in an ISA. Financial service providers like to blur this distinction so that they can sell you the whole package. And once they've got you they can rely on you not to pay too much attention when they raise the charges, or when the in-house funds they have put you into fail to perform.
Some ISAs charge up to 5% initial fee and 1.5% per annum thereafter. This will kill your returns (compounding). And don't think you will get any special management expertise. These fees will be spent on sales commissions and marketing expenses. Any hot investment manager (if there is such a thing) will be assigned to high profile specialist funds. Not to general funds aimed at the inexperienced public.
The facts (2020)
Each individual can place up to £20,000 per year in an ISA, in a wide, but not totally unrestricted, range of assets. All such assets are free of both income and capital gains taxes.
You can take cash out of an ISA but you cannot later put it back again. Further you cannot carry an unused ISA allowance forward from one year to the next. It's 'use it or lose it'. To fail to use an ISA allowance is to turn down a tax free fund for life - particularly damaging when there is lots of life left - i.e. you are young. That is precisely when you are least likely to be able to afford it.This is what makes the personal decision difficult.
HMRC summary here
Choosing an ISA
The two themes are flexibility and low cost. Your ISA could be for life. Without flexibility you cannot adjust to meet changing circumstances, nor do you have any defence against rising costs. ISAs that satisfy these conditions will almost certainly be simple, not heavily promoted, and without sign-on inducements.
- one that will allow you to hold a good range of investments. ISAs described as "self-select" will do that. There are lots of them.
- low account management charges
- ability to transfer cash out and repay it later (subject to regulations, currently restricted to same tax year)
- low dealing charges. These may be higher than for dealing in your usual share account.
- ability to move investments to your share account without sale and repurchase
- no exit fees
It is extraordinarily difficult to give generalised advice on ISAs. Every point below should be qualified with the words 'probably' and 'depending on your personal circumstances', and it is for you to do the maths that will help you make your own decision:
- It can't be emphasised enough, and we repeat it here, it's 'use it or lose it'. A contribution to an ISA will generate tax-free income for the rest of your life. You may be a low taxpayer now, but will you still be a low taxpayer in 30 years time? If you miss a contribution in the current year you can't change your mind and put it in later.
- The worst that can be said, if you open an ISA and later want to withdraw the investment, is that you will have wasted the annual administration fees charged to the account but saved a bit of tax on dividends and capital gains during that period.
- The tax benefits of a SIPP are more than those of an ISA, but there are some restrictions on the use of SIPP funds that do not apply to an ISA.
- If you have decided not to use an ISA allowance, why don't you at least put some of your cash cushion into it and save income tax on the interest until such time as you need the cash?
- ....but if you put cash in an ISA you can't get at it without losing any future tax benefits. Isn't liquidity the whole point of cash?
- .....and the return on shares should be better than the return on cash. If the equity risk premium is 3% then in 30 years time you will be getting tax relief on a sum that is two and a half times bigger than the cash equivalent.
Specialised ISA wrappers
The government of the day occasionally float specialised ISAs to target some particular voter-sensitive issue. Currently it is young couples attempting to buy their first house. If you or yours are aged 18-40, and particularly if you are potential first-time house buyers, a 'lifetime ISA (LISA)' could be just the ticket.