Q&A: Using Isas for tax planning

Individual savings accounts are a tax-efficient wrapper into which you can place your assets and stop the taxman grabbing a slice of your investment returns. But how should these products fit into your overall tax planning? And which funds should you choose to place inside this year’s stocks and shares Isa?

Paul Kennedy, head of trusts and tax planning at Fidelity FundsNetwork answered readers’ questions on how Isas fit within your wider portfolio of investments for tax purposes and explains the rules.

And Darius McDermott, managing director at Chelsea Financial Services answered questions on fund recommendations and new Isa launches.

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The stock market went up quite a bit last year but it still seems to be pretty volatile. Is now a good time to be putting my Isa money into an equity fund or should I stick to cash? Christina Wynn, Shrewsbury, Shropshire

Darius McDermott: If you are investing for the long term i.e. ten years plus, then it is absolutely fine to make an equity investment now. I do agree with you; the market is quite volatile at the moment, but one way to help mitigate market volatility is by investing on a month by month basis to achieve what is known as “pound-cost-averaging”. This means your contribution buys more units in the fund when prices are low and fewer when prices are high. This cushions you from dips in the stock market because you are buying your units at a variety of prices rather than all at once at a fixed price.

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Paul, is there any point in using an Isa wrapper for equity investments? Most of the benefits of an Isa are in not paying income tax, so surely the benefits are better if you invest in a corporate bond fund? Katja Klug, London

Paul Kennedy: The benefits of an Isa is that all investment return is free of all taxes, so that includes both income tax and capital gains tax. Often, equities pay dividends and outside of an Isa these may be subject to income tax, although this is zero for a basic rate taxpayer and 25 per cent on the net amount received for a higher rate tax payer (and 36.11 per cent for any 50 per cent taxpayer after April). So, outside an Isa you may have to pay tax on the dividends as you go meaning you lose part of the return in that year and obviously, have less to carry forward to invest next year.

The capital gains from equities are subject to capital gains tax at a current rate of 18 per cent where gains in a tax year exceed the annual allowance of £10,100. Inside an Isa there would be no personal tax on the dividends and no tax on any capital gain. So, there are potential tax savings to be made with equities & Isas, these will differ according to your own tax status. With corporate bonds the main return will be interest which would be subject to income tax and therefore saved in an Isa. There is tax benefit in both types of investment and ultimately, I would say never invest in a certain type of investment purely to reap the greatest tax reward. Always invest in the type of investment that meets your objectives and attitude to risk and take that tax boost that comes with it.

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Paul, As a basic rate tax payer, is there any point in me using an Isa? Higher rate payers get much more benefit don’t they? Sophie Blythe, Chelmsford, Essex

Paul Kennedy: Whether an Isa provides a tax advantage (and the amount of that advantage) depends on whether and at what rate you would otherwise have to pay tax on the investment return if it were outside an Isa. So it follows that as a higher rate taxpayer would pay a higher rate of tax on their investment returns they will gains more from an Isa. They don’t actually get more from the Isa than a basic rate taxpayer they just save more tax. But do not confuse this with it meaning Isas are not worthwhile for a basic rate taxpayer. Interest, whether from cash, corporate bonds or gilts (and fund comprising of) would all be charged to income tax at 20 per cent for a basic rate taxpayer and so the Isa provides a very worthwhile tax saving. Similarly, capital growth in excess of the annual allowance would be taxed at 18 per cent. Over time and ongoing contributions these tax savings can amount to a substantial amount of money even for a basic rate taxpayer.

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I have a cash Isa with Scottish Widows that earns a paltry 2.1 per cent. I did not pay anything into this year. Instead I opened a funds ISA with Halifax and have enjoyed a 12.5 per cent return instead. I plan to do the same next year but I want to move my cash Isa to another provider that pays a better interest rate. I assume that as long as I move my cash Isa elsewhere and don’t pay anthing into it, I won’t break the rules and can continue to pay the full amount into my funds Isa. Is that correct? And which cash Isa would you recommend? (I want to be able to access the cash Isa as I am using it for a deposit on a house).Many thanks. Kind regards, Jack Shepherd, London

Darius McDermott: You can only have one cash Isa provider per tax year, but you can switch providers without losing any of your allowance. Currently, the best instant access cash Isa for transfers out there is offered by First Direct with a 2.72 per cent rate of interest (please note that this is a six-month introductory rate so it is very important to monitor the interest payment thereafter).

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I am new to investing and this year began saving into unit trusts for the first time. I have been surprised to see just how much of my contributions have been eaten away by charges. Is there a way to avoid these fees? Richard, West Hampstead

Darius McDermott: Good afternoon Richard. You are correct, nearly all unit trusts, whether placed in or out of an Isa wrapper, take substantial initial charges from your investment. These do vary from fund house to fund house, but typically are between 3 and 5.5 per cent of your investment. These fees can be almost entirely avoided by using a discount broker, who should be able remove the majority, if not all, initial charges. Some of the best discount brokers have been established for almost thirty years – dare I say, my own firm is now in its 28th year.

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I an one of the Attorneys for my mother who is 97. She has a large amount of cash in the bank and stocks& shares. Should I encourage her to do a cash or stocks and shares ISA ?. The stocks and shares Isa has a problem that unless its free the cost of dealing will wipe out the tax saved in year 1 - and I cant count on there being a year 2 - would a cash Isa be better ? Clive nicholson, UK

Darius McDermott: Given your mother’s fine age, I would suggest that putting her cash into a stocks and shares Isa to be a very unwise move as you run the risk of a severe market correct wiping the value off a portion of her assets. A cash Isa makes far more sense as she needs cash and income now to fund the twilight years of her retirement.

Paul Kennedy: As you have probably recognised, the tax advantage an Isa provides relates to whether and at what rate the investor would otherwise have to pay tax on the investment return if it were outside an Isa. The term of the investment plays a part in this outcome because of the effects of compounding and the interaction with the CGT allowance.

However, nobody should ever invest in a certain type of investment purely to reap the greatest tax reward. Always invest in the type of investment that meets your objectives and attitude to risk. That said, where someone is investing sums of money in excess of the Isa allowance and have a broad range of investment requirements, including stocks & shares, corporate bonds, cash etc they might wish to consider how their Isa allowance could be used. Most would probably say invest in what you feel happy with and take what tax benefit comes. If you have the luxury of plenty of money well then try to make sure you use your capital gains tax allowance in addition to your Isa allowance and sometimes that can dictate what goes where.

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I’m considering purchasing a property ETF, IUKP, within an ISA. Is this maximally tax efficient, or will I lose 10 per cent of the yield to tax? The tax treatment of a property ETF within an ISA seems murky; is the yield treated as a stock dividend or as a bond yield? Simon Badwin, Bedfordshire

Paul Kennedy: Simon, I like the phrase ‘maximally tax efficient’ and I suspect what you mean by this is whether a particular structure of a type investment will confer more or less tax advantage than accessing the same broad asset class through a different structure. ETFs can be structured in a number of ways, can provide exposure to the asset class in differing ways and can be based in various jurisdictions.

I am afraid there is no simple answer, you have to get under the bonnet of each, see how and in what they they are investing, what returns are being produced, how these are taxed in the home jurisdiction, then look at how this is ceded back to the ISA manager so see what tax the Isa can effectively recover. The tax treatment of a property fund (let alone ETF) is complex. First, you need to understand what exactly they are investing in. You rightly recognise that one must look at what the fund is paying and what goes on in the fund itself. PAIFs & REITs are able to stream out separate forms of ‘income’ (rent from property/dividends from holding / interest from cash).

Where it’s streamed in this way the Isa manager may be able to recover tax on the rent/interest. If the property fund only pays a simple dividend (and the rent is taxed within the fund) then the Isa manager cannot recover this because they have received only a dividend. In the context of a small one-off Isa investment then one needs to be careful not to get carried away with tax too much as I guess it won’t have a profound affect compared to the fund performance but where substantial funds are at stake these matters can be important.

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Could you explain the pros and cons of holding individual shares within an ISA compared with buying them outside this wrapper? Terry Wilson, London

Paul Kennedy: Shares held outside an ISA generally pay a dividend and over time one hopes they grow in value. Any dividends paid are subject to annual income tax although this is zero for a basic rate taxpayer and 25 per cent on the net amount received for a higher rate tax payer (and 36.11 per cent for any 50 per cent taxpayer after April). So, you may have to pay tax on the dividends as you go meaning you lose part of the return in that year and obviously, have less to carry forward to invest next year. The capital gains from shares are subject to capital gains tax at a current rate of 18 per cent where gains in a tax year exceed the annual allowance of £10,100. Inside an Isa there would be no personal tax on the dividends and no tax on any capital gain.

Darius McDermott: Outside of Isa you will be liable to pay capital gains on the those individual shares past your yearly CGT allowance. Further, if you held the stocks within an Isa you will not be liable to pay tax at your marginal rate on any dividends paid out.

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Like thousands of US citizens working in the UK and filing/paying taxes both in the UK, as well as in the USA, I have been told that Isas are not tax efficient for me because the USA does not recognise the tax wrapper, ie they are an ‘offshore investment’ and thus I must pay ’income tax rates’ to the USA, not the lower dividend/interest rates on any interest, dividends as well income tax on any cap gains. I am also told that any losses on such offshore investments cannot be balanced against any gains. Is this correct? Is anyone working to get the USA to recognise the Isa wrapper? C Murray, London

Paul Kennedy: Mr Murray, you allude to an important point for anyone that may potentially face tax in two or more different countries. Sometimes an individual can be a UK tax resident (thus qualify to effect an Isa) and also have to file/pay tax in another country as well as the UK.

Where this happens, the rules can be very complex with tax treaties often operating to determine what tax is paid in the UK and in the other country. The Isa is a product of the UK tax regime. For the purposes of UK tax (and UK tax alone) the returns from an Isa are free of all UK personal tax - so they are ‘tax-efficient’. However, how the other country treats the returns from an Isa is a matter of that country’s tax law. Just because there is no tax to pay in the UK it does not automatically follow the same treatment that applies in the other country.

The USA has some very complex rules for non-US investment funds (PFICs) that can give rise to some of the tax effects you suggest, whether in an ISA or not. This may not mean that all types of Isa investment are ‘bad’ in the way you suggest, but simply that there are some that you may prefer to avoid for reasons of tax or complexity. Ask your US tax adviser, who will know your circumstances, specifically whether the US would treat all potential Isa investments in this way or just some?

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Dear Paul & Darius, I am uncertain about what to do with my £10,200 ISA allowance which I have yet to use for 09/10. I have a house valued at £500,000 with a £200,000 interest only mortgage fixed at 3.5 per cent – Aug 2015. I have approx £2,000 in an online Nat West account for the odd necessity. I have £15,000 in Abbey national cash Isas (5yrs x £3k), and £40,000 in ING direct paying almost no interest at all. I will be receiving a cash sum of about £50k in 2015. I am 52 years old and plan to retire at 65. I earn about £40k a year in the charitable sector & have no debts. I am interested in a medium risk investment (I think) for my ISA. I will also be buying a new ISA on 6 April so need to know if I should ovest in the same thing or something different.

I would appreciate your advice. Kind regards, Virginia Greenwood

Darius McDermott: With 13 years to retirement, and given that you are debt-free and cash-rich, you can afford to take on a little additional risk by investing this and next year’s Isa allowances in the stock market.

A medium-risk investment suits Virginia’s profile; this is best attained via exposure to a mix of equity and fixed income unit trusts that further spread risk across typically 30-40 holdings each. We would split her £20,400 across six funds with approximately 60 per cent weighted in equities; 40 per cent in bonds. We recommend that she should have two funds in the UK equity income space; for example, Invesco High Income and Artemis Income – these are funds looking for strong defensive, cash-generative companies that will maintain dividends.

Currently over half the FTSE All-Share dividend can be attributed to just six companies, so it is important to seek some diversification elsewhere, thus we feel Virginia should gain exposure to a selection of global income funds (e.g., Newton Global Higher Income) that will grow her pool of potential dividend-payers. Finally, Virginia should look to choose a couple of go-anywhere bond funds that have the flexibility to invest in gilts and investment grade and high-yield corporate bonds (e.g., Henderson Strategic Bond) – the effect of having the bond funds in her portfolio will reduce risk and increase interest payments. From this mix of assets and funds, Virginia can expect a good stream of income in her retirement and the potential for capital growth.

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iShares IEGE is an ultra-short term bond ETF that appears to be a decent cash proxy, it can be placed in a stocks and shares self-select ISA, and I believe it is not subject to 10 per cent dividend tax. This combination, then, seems like it would make a decent way to temporarily hold cash in an ISA, and in fact could beat a standard cash ISA long term, even after charges, for both basic and higher rate taxpayers. I’ve never seen this idea recommended, though. What am I missing here? Simon Baldwin

Paul Kennedy: You need to check how the ETF is structured for tax purposes before you can ascertain the likely tax effects, possibly it is a distributing, interest paying fund? Dividends have never been subject to a 10 per cent dividend tax and this misconception arises from the rather archaic way we run dividend tax.

In effect, a company pays a dividend of £100, then we pretend there is a tax credit of £11.11 and then say that the investor received a gross dividend of £111.11.

There never was a dividend of £111.11 and nobody took £11.11 of it. Previously, the Isa manager could recover the tax credit of £11.11 but this wasn’t recovering the tax that HMRC had already deducted from the dividend, it was a effectively an extra amount thrown back in from Govt. coffers.

Dividends from offshore funds used to be subject to 10 per cent or 32.5 per cent personal income tax charge but this was changed in the Budget and they are now mostly treated in the same way as UK dividends. As to the investment itself, as you say it provides exposure to a diversified basket of Euro-denominated government bonds with maturities ranging from 0-12 months and however one scopes this there are some differences to cash per se as one suspects that capital values might be influenced by any changes to interest rates.

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Is it correct that the rules permit the full Isa allowance, £10,200 to be invested in Permanent Interest Bearing shares?

What are the advantages and disadvantages of buying Nationwide Pibss at £88 to yield 7.10 per cent gross, or Nationwide £97 yielding 7.47 per cent? Aubrey Selig

Darius McDermott: Yes, you can put a Pib in an ISA. When you look at a yield-to-cost ratio there is virtually nothing to chose between the two. It is important to remember that they do not fall under the Financial Services Compensation Scheme. Also, as they are undated stocks they are particularly sensitive to interest rate change.

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My question is: “Time and time again, I read reports on Isas by professional investment advisors, commentators and journalists, who state that there is no income-tax-saving advantage for the standard-rate taxpayer, without ever mentioning the fact that there is firstly a very substantial saving for any interest - paying holding, (including Gilts, for example, and also a worthwhile one for dividends paid gross, e.g. by most funds and companies based offshore. (Most of my own ISA holdings are in funds based in the channel-islands, or in corporate-bond-holding Unit Trusts, for these reasons, and have been for years). Please would you explain why these important aspects are continually ignored?”

Paul Kennedy: I share the same frustrations as you! Whether an Isa provides a tax advantage (and the amount of that advantage) depends on whether and at what rate you would otherwise have to pay tax on the investment return if it were outside an ISA. Interest, whether from cash, corporate bonds or gilts (and fund comprising of) would all be charged to income tax at 20 per cent for a basic rate taxpayer and so the ISA provides a very worthwhile tax saving. Similarly, capital growth in excess of the annual allowance would be taxed at 18 per cent.

Over time and ongoing contributions these tax savings can amount to a substantial amount of money even for a basic rate taxpayer. However, a basic rate taxpayer would not pay tax on dividends outside an ISA so solely for dividends in isolation there is no tax advantage. As you say, it seems that many tar the whole thing because of this alone. Previously, the Government used to add a 10 per cent ‘bonus’ to dividends received by the Ias manager but this was abolished some years back. That did not however mean that dividends became taxed within an ISA simply that the credit was abolished. I don’t therefore feel there can be any concept of a gross dividend (rather than interest) from an offshore fund.

Darius McDermott: Michael couldn’t be more correct. That one avoids savings tax on any interest-paying holding – and bond funds that have more than 60 per cent invested in bonds – is something we at Chelsea have really been impressing upon our clients. Furthermore, ISA investors do not pay tax on any income taken out from an ISA at their marginal rate. These are reasons alone to begin investing in an Isa; it is entirely lost on me why the investment industry is not shouting this from the rooftops. And that is not even to mention that ISA investors are not applicable to capital gains tax.

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