How to Win the ISA Game

What if I told you about a legal way to pay less tax? Would you want to learn more?

That’s exactly what you get with an ISA. The government gives you a tax break for investing your savings. Why wouldn’t you take advantage?

Yet fewer than 5% of Brits have a Stocks & Shares ISA, and most of us are confused about how they work. Let’s make it simpler.

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ISAs all have something in common – they are tax-efficient.

You’ve already paid tax when your salary lands in your bank account, but from that point forwards there is no tax owed within an ISA. This is a major advantage for the ISA.

Outside the ISA wrapper, for example in a General Investment Account (GIA), your gains would be susceptible to capital gains and dividend tax.

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There are four types of ISA:

• Innovative Finance ISA

• Lifetime ISA (LISA)

• Cash ISA

• Stocks & Shares ISA

Innovative Finance ISA

You can ignore this one. It exists for investments into peer-to-peer lending and crowdfunding. But these are unnecessary complications for a personal finance framework. So just leave it alone.

Lifetime ISA (LISA)

There are two ways to use the LISA.

You can use it to save up for your first home, or for savings later in life. You can contribute up to £4,000/year, and the government will add a 25% bonus to your contributions.

If you use it for your first property, the government bonus works in your favour and bolsters your deposit. If you don’t – because the property price is above the £450k threshold – then you can continue contributing up to age 40, and effectively use it as a pension. And the government still gives you a 25% bonus.

If you don’t use the LISA for a house deposit, you need to keep your money in the wrapper until age 60. Otherwise, you will lose all the government bonuses you have gained up to that point. If you use it for a house, however, withdrawing assets before age 60 is absolutely fine.

Within a LISA, you can choose to hold your money in cash, or to invest it in stocks & shares. We’ll come onto that choice shortly.

Cash ISA

A Cash ISA is simple – you receive an interest rate on your money. The advantage – versus a current account – is that you don’t pay tax on your gains within the ISA wrapper.

Stocks & Shares ISA

A Stocks & Shares ISA will be the engine of your investment growth. It allows you to buy into stocks, funds and ETFs. In the short-run, the cash ISA may seem like the low-risk, appealing option. But in the long-run, the stocks & shares option will yield you better returns.

In this example, the cash ISA generates a steady 3%/year. The Stocks & Shares ISA generates a volatile 7%/year (a sensible long-run assumption from investing in a diversified stock portfolio).

As you can see, there are years where the Stocks & Shares ISA does worse than the cash ISA. But over time, the stocks & shares ISA, set up correctly, will win out, by some margin.

If you knew you needed to use your ISA money in the short-term (i.e., the next 12-18 months), it could make sense to leave your assets in cash, to avoid losing your house deposit, for example. But over a longer time-frame, you'd be better off investing sensibly than holding savings in cash.

A cash ISA might seem less risky, but over a longer period it's almost guaranteeing you a lower return than a stocks & shares ISA.

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Each tax year (April to April), you can contribute up to £20,000 across the combination of your ISAs, and returns are tax-free while they are in the wrapper. When you withdraw money from the ISA, you won’t pay any tax. It’s a tax-efficient way of growing your savings.

Stocks & Shares ISA vs General Investment Account

You might ask why it’s worth using an ISA rather than a General Investment Account (GIA) – a normal account for investing. The answer is tax. If you assume a 7% annual return in your investment portfolio, none of this would disappear to tax in an ISA wrapper.

However, if you’re invested within a GIA, you would pay capital gains tax of 20% (if you’re a higher rate taxpayer, or 10% if you’re a basic rate taxpayer).

As such, up to 20% of your gains – or 1.4% - would be paid in tax, and you’d only receive 5.6%. Moreover, if the investments you hold pay dividends, you’d also be liable to dividend tax in a GIA (but not in an ISA). Over the short-term the difference may seem small. But over a longer period, that’s a major difference.

The graph below shows the difference between the ISA and GIA over 30 years, assuming a 7% return, capital gains tax of 20% and no dividends.

By investing in an ISA, you end up with 60% more gains than you would have done by investing in a GIA. If that doesn't incentivise you to set up an ISA, I don't know what will!

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ISAs exist to help you grow your savings. They are a legal loophole designed to encourage savings and investment.

The key points are:

• You don’t pay tax on gains or dividends within an ISA.

• Stocks & Shares ISA will generate the largest returns for you over the long-term

• As your gains grow within the ISA, your tax benefit grows. When your gains are £100/year, your tax benefit vs a GIA is only £20/year. But when your ISA generates £100,000 of gains, your tax benefit is £20,000/year. So don’t withdraw money from your ISA until you really need to.

It’s no coincidence that the 5% of people with a stocks & shares ISA tend to be the wealthiest 5%...

So if you don’t yet have a Stocks & Shares ISA, open one today, and contribute £50/month to it to get started. If you don’t know how, email me and I’ll help you.

Winning the ISA game will make you tens of thousands of pounds more over your lifetime. It's worth understanding.