As the tax year-end looms, Laura Suter considers six ways to make the most of your Isa pot.
Don’t be put off by Brexit
While it is understandable that people are worried about the uncertainty that Brexit and other short-term political dynamics are creating for stockmarkets, it is important to remember that there is a difference between putting money into your Isa and actually investing it.
The annual Isa allowance is a use it or lose it tax break. You can’t roll it over to other years like the annual pension or capital gains tax allowances.
So, if you have money that you want to invest for the long term, but you are waiting until we know more about Brexit before you decide where to invest, make sure that you get it into your Isa account before 6 April because you can then leave it in cash for a while before actually making any investments.
While you shouldn’t leave it in cash within a stocks and shares Isa for too long, it is fine for a short period of time, and better than losing your Isa allowance, which can be very valuable over the long term.
Take some risk
Around 72% of Isa money is in cash, likely earning measly interest rates. Holding cash is smart, if it’s to meet short-term spending needs, as an emergency pot and if you want a low-risk investment.
But if you’re willing to dip your toe into the investment markets, you could make more money over the long term. Inflation is currently around 2%, which means that you need to make at least 2% on your cash Isa account in order to keep up with rising prices.
The only way that you can get that within an Isa at the moment is by tying up your money in a five-year fixed rate account, with the top easy-access cash Isa account paying around 1.5%.
The difference between cash and investment returns adds up over the longer term. Studies of long-term stockmarket returns show that they average around 5.5%, after inflation, so around 7.5% at the current rate of inflation.
On a £10,000 Isa pot, after 10 years the investment would have grown to £18,771, assuming 7.5% annual return and 1% charges.
In that same period, a cash account with a £10,000 initial investment would have been turned into just £11,605. After 20 years, the difference between the two pots would be £21,768.
Get free government cash
With a Lifetime Isa, you can get up to £1,000 a year in government bonus, up until the age of 50. If you opened a Lifetime Isa at age 18, that is a maximum government bonus of £32,000 (or £33,000 if you’re lucky enough to have your 18th birthday before 6 April).
The Lifetime Isa is open to those aged 18 up to your 40th birthday, and you can save up to £4,000 each year – either in one or more lump sums, or as a regular monthly saving.
From the age of 50, you no longer get the government bonus, but you can carry on paying into the account. You can withdraw Isa money once you’ve reached 60, or to buy your first property, but be warned that if you take the money for any other reason you’ll pay a 25% exit penalty.
Put your income investments in an Isa
The amount of dividend income that you could receive tax-free was cut from £5,000 to £2,000 last April.
Any dividend income that you receive above this amount is taxed at 7.5% for a basic-rate taxpayer, 32.5% for a higher-rate taxpayer, or 38.1% for additional-rate taxpayers.
As the tax year ends, people should make sure that they put as much of their dividend-producing assets in their Isa as possible to avoid getting walloped with a tax bill.
In pounds and pence, someone who receives £5,000 in dividends would previously have paid no tax, but this year they will have a tax bill of £225 if they are a basic-rate taxpayer, £975 if they are a higher-rate taxpayer, and £1,143 if they are an additional-rate taxpayer.
Assuming 4% income on your investments, anyone who has more than £50,000 invested in dividend-producing assets outside an Isa is likely to be hit by this cut. However, if you have this money in an Isa you won’t be taxed a penny of income tax on this pot.
An investment pot of £100,000, which is yielding around 4%, means that an investor will save £150 a year in income tax if they are a basic-rate taxpayer, £650 a year if they are a higher-rate taxpayer, and £762 a year if they are an additional rate taxpayer, if their money is in an Isa rather than a normal investment account.
Dividends received on investments within Isas are free of any income tax, so they can be withdrawn with no tax liability. However, if you don’t need the income, reinvesting it to buy more shares in the same investment can have a dramatic impact on the size of your Isa fund over the long term.
This is because when you buy more shares each time that you receive a dividend, you then receive more dividends next time there is a payout, which can then be reinvested again, and so on. Some investment platforms allow you to set this up to happen automatically.
Let’s take the example of someone investing the full Isa allowance of £20,000, while assuming the FTSE All-Share’s long-term averages of a compound annual growth rate of 5.5% and annual dividend yield of 3.5% a year.
After subtracting 1% a year for platform administration and fund fees, the initial £20,000 will be worth £47,729 after 20 years. A total of £21,834 would also have been banked in cash dividends to give a total return of £69,563.
However, an investor who reinvests the dividends rather than banking them would have £91,678 – more than £22,000 extra. The figures become even more attractive over longer periods.
Source: AJ Bell
Beware of charges
There can be a wide disparity between the charges levied by investment platforms and asset managers. The differences can appear small in percentage terms, but over a long period, investment charges can have a significant impact on the value of your investment pot.
Higher charges are not necessarily bad if they are for a service or investment that you value highly, but if you are paying more for something that you don’t use, or a mediocre service, you could just be eating into your investment returns unnecessarily.
For example, the UK regulator recently said that fees charged by investment platforms range from 0.22% to 0.54%.
The cheapest active fund in the UK All companies sector is 7IM UK Equity Value with an ongoing charges figure (OCF) of 0.35%, and the most expensive in the sector is Candriam Equities L at 2.34%.
So, holding the cheapest UK all companies fund on the cheapest fund platform could cost 0.57% a year, whereas holding the most expensive fund on the most expensive platform could cost 2.88%.
Assuming a gross investment return of 6% a year, on a £20,000 Isa investment, the difference in fund value after 20 years would be a whopping £20,612 (£36,973 compared with £57,586).
Laura Suter is a personal finance analyst at investment platform AJ Bell.