How can ISAs save tax?

Gareth Shaw / 26 January 2016 ( 05 April 2017 )

Investing your money could help you generate a better income, and with an ISA you could save yourself a significant amount of 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.

For more information on ISAs as an alternative saving option, please click here.

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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The opinions expressed are those of the author and are not held by Saga unless specifically stated.

The material is for general information only and does not constitute investment, tax, legal, medical or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.