How can ISAs save tax?

Question

Whenever I read about individual savings accounts (ISAs), they’re described as ‘tax-efficient wrappers’. What does this mean? How much tax could I save?

Answer

ISAs are enormously popular – according to HMRC, more than 13 million people opened one in 2015, by which point a whopping £79 billion had been invested in them in total. 

Part of the attraction is that you don’t have to pay tax on the money you make from your ISA investments – and from April 2017, you can invest up to £20,000 per tax year.

A ‘wrapper’ is a bit of financial jargon that basically describes a product or account into which you can save. 

ISAs are one kind, but pensions and investment bonds are also described as ‘tax-efficient wrappers’. As for how much tax you can save, it all depends on the type of ISA you have, and where you invest.

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Should you invest in a stocks and shares ISA?

Income tax

Under current rules, income tax is charged on interest you earn in a savings account. 

If you’re a basic-rate taxpayer – meaning your annual income is between £11,001 and £43,000 – you’ll pay 20% tax. Say you’ve got £50,000 in a savings account earning 3% a year. You’d earn £1,500 in interest, but must pay £300 in income tax, leaving you with £1,200.

Higher-rate taxpayers (those earning between £43,001 and £150,000 a year) and additional-rate taxpayers (earning even more) pay 40% and 45% tax respectively. 

In our example, this means tax bills of £600 and £675, reducing your income to £900 and £825.

Hold your savings in a cash ISA and there’s no income tax to pay. This could boost your income by between £300 and £675 in our example.

If you invest your money in bonds or bond funds – loans to Government or companies in exchange for a fixed interest rate – the income you earn is subject to income tax. But, you guessed it, interest from bonds in a stocks and shares ISA is tax free.

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What are the different types of ISA?

Dividend tax

When a company makes a profit, it gives some of this back to shareholders in the form of a dividend. 

Unfortunately, dividends often come with a tax bill. Much like income tax, the amount you pay depends on your income. If you’re a basic-rate taxpayer, you don’t have any further tax to pay, because the Government automatically deducts 10% tax directly from the companies before they pay your dividend.

But higher-rate taxpayers must pay an additional 25% tax on dividends, while additional-rate taxpayers pay 30.56%. 

If you earned £2,000 in dividends in a year, you’d pay tax of £500 at the higher rate and £611 at the additional rate.

Hold shares or funds in a stocks and shares ISA, and you can save on this tax altogether – apart from the 10% deducted before your dividends are paid.

Read our guide to understanding the basics of investment

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Capital gains tax

You’ll encounter this if you sell your investments and make a profit. 

Capital gains tax (CGT) is charged at 18% if you’re a basic-rate taxpayer or 28% if you’re a higher- or additional-rate taxpayer. (But if you’re a basic-rate taxpayer and your taxable income and taxable capital gains added together come to more than £31,785 after deducting your allowances, then you too will pay CGT at 28%). 

The Government allows you to make a certain amount of profit before you pay CGT – currently £11,100.

Say you bought shares in 2005 worth £10,000 and sold them today for £25,000 – that’s a £15,000 profit. After the tax-free allowance, you’ll have to pay CGT on the remaining £3,900, leaving a bill of £702 or £1,092. But CGT doesn’t apply to profits you make when you sell investments held in an ISA.

Saga Investment Services offers a great ISA that allows you to grow your money tax-efficiently on one easy-to-use website. Its dedicated team of friendly experts are available six days a week to help you understand your ISA options and how these popular ‘wrappers’ work.

Next article: Can you inherit an ISA from your spouse?  >>>

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