What is a tax-free ISA wrapper?
ISAs, or individual savings accounts, were introduced by the government in 1999 as a way of encouraging people to save. An ISA is best described as a tax wrapper, which means it can protect your savings or investments from tax on capital gains, dividends and interest.
The specific benefits of the tax wrapper depend on the type of ISA you have. Below we’ll look the two main types – cash and stocks and shares – and show you how they can make your money go further.
If you put money into a cash ISA, any interest you earn is free from tax. This can represent a significant saving, especially if you’re a higher-rate taxpayer.
The introduction of a new personal savings allowance in April 2016 means that all basic-rate taxpayers can now receive £1,000 of savings interest tax free, and higher-rate taxpayers can receive £500. While this reduces the need for cash ISAs for those with smaller pots, those intending to build up a larger amount over several years could benefit significantly.
For example, if you have £100,000 in an ISA paying 2.5%, you’ll receive £2,500 a year in tax-free interest. Outside of an ISA, you’d be paying 40% tax on £2,000 of that annual interest (if you’re a higher-rate taxpayer), meaning you’d only take home £1,700 in total.
Stocks and shares ISAs
There are many different types of investment that can be held within an ISA, including individual stocks and shares, unit trusts and corporate and government bonds. In all of these cases any dividends you receive from your investments will be tax free.
These savings become significant as you start to build a large investment pot, say if you utilise your £20,000 allowance in full over five years or more.
Outside of an ISA, the first £2,000 you receive in dividends will be tax free after April 2018 (the first £5,000 before this). Anything over that level is taxed at 7.5% for basic-rate taxpayers, 32.5% for higher-rate taxpayers and 38.1% for additional-rate taxpayers.
If you have a £100,000 portfolio held outside an ISA that’s paying dividends of 3.5%, you’d be exceeding the £2,000 tax-free threshold. That means if you’re a higher-rate taxpayer, you’d be paying £1,137.50 in tax on your dividends.
An ISA also shelters you from capital gains tax when you come to sell any investments that have gone up in value. If, on the other hand, you invest in shares outside of an ISA that make gains of £20,000, you could pay capital gains tax of up to 28% when you sell them – a cost of £5,600.
However, you only have to pay capital gains tax if your returns exceed the annual limit, which currently stands at £11,300. If you make a smaller gain, or choose to sell your portfolio across several tax years, you could be exempt from the tax entirely.
As these examples show, the benefits of using an ISA increase as you build your savings or investments. ISAs also give you the flexibility to transfer your money between cash savings and investments, as well as between providers, without losing the benefits, making them a very adaptable form of financial planning.
Want to know more about Stocks and Shares ISAs?
The UK tax year ends on 5th April each year. This is the deadline to make a deposit into your ISA using your annual allowance. Learn how you can open an ISA with us or transfer an existing ISA from another provider.Learn more about Saxo ISAs