Three types of investment account that every UK investor should be aware of are: the individual savings account (ISA), the pension and the standard investing account (also known as a ‘dealing’ or ‘trading’ account). All enable you to hold a variety of assets inside, but they differ significantly in terms of their ability to shelter your wealth from tax. So it’s worth being clear about their distinct pros and cons.
The Individual Savings Account (ISA)
Every UK investor should consider opening an Individual Savings Account (ISA). The ISA is one of the simplest ways to shelter savings and investments from tax, and you can hold a wide range of assets inside it, including cash, stocks, bonds and investment funds.
You don’t have to pay any Capital Gains Tax (CGT) on any profits you make on assets held in an ISA. And you don’t have to pay any tax on the income those assets generate – except dividend income, which has a 10% tax deducted automatically when it is paid out.
You can pay up to £15,240 into an ISA in the current tax year, which ends on 5 April 2016.
There is no limit to how big your portfolio can grow in an ISA. Indeed, the number of ‘ISA millionaires’ – people who now have over £1m in their accounts – is reportedly growing fast.
If you don’t use up your ISA allowance before the 5 April deadline then you’ve missed your chance forever. As the new tax year begins, a new allowance will apply, but you can’t carry over any unused amount from the previous year.
It’s also vital to understand that any payment you make into an ISA reduces your allowance for the given year by the same amount. You should only consider making a withdrawal from an ISA when you have exhausted any other non-tax efficient savings you may have – otherwise you’re just wasting the opportunity to shelter that money from tax.
This point becomes especially important if you intend to transfer your ISA from one provider to another. You should never attempt to do so by simply withdrawing money from one account with the intention of paying it into another. Instead, you should get your new provider to carry out the transfer on your behalf. This will ensure that the money you’ve saved so far will remain sheltered from tax, and won’t count against your allowance for the current year.
Finally, it’s worth pointing out that you can’t use an ISA to hold certain advanced types of investments, such as derivatives and short-dated bonds.
The pension is one of the oldest examples of tax-efficient investing. It exists because governments want to encourage and help people to save and invest for their futures.
There are various different forms of pension, each of which gives you a different level of control over the investments that are put inside. Most people choose to let a professional investor manage their pension portfolio but it is possible to do all the work yourself via a Self-Invested Personal Pension (SIPP), if you feel confident enough to do so.
As with an ISA, you won’t pay any CGT on investments held in a pension, and you won’t pay any tax on the income earned by those investments except dividend income – where a 10% tax is paid automatically and can’t be reclaimed.
More importantly, any contributions you make to your pension – up to a maximum allowance of £40,000 or 100% of earnings each year – receive tax relief. This means that if you choose to contribute some of your own net income to your pension pot then the government will return some of the tax you’ve already paid on that money.
As of this year, you can do a number of new – and highly significant – things with your pension when you retire. For example, you can choose if you wish to withdraw your entire pension pot as a lump sum, subject to tax.
Funds committed to your pension are tied up until you are at least 55. There is also a lifetime limit to the amount that you can keep in a pension: currently £1.25m (falling to £1m from 6 April 2016). And while the pension fund itself is tax-efficient, when you come to draw an income, you’ll find the taxman wants his cut (unlike with an ISA).
The range of permitted investments is wider than with an ISA but there are still some restrictions. And don’t forget that as pension arrangements can be complex, you will need to consider a number of additional costs and charges.
The standard investing account
Many investors have standard investing accounts running alongside their ISAs and pensions, for two main reasons: (1) because they’ve used up their tax allowances with other accounts; and (2) because they want access to types of investments or features that they can’t get elsewhere.
These accounts vary widely in terms of their capabilities and in the ways that they’re named. At Old Mutual Wealth, for example, our standard investing account is called the Collective Investment Account (CIA), because it’s designed to give access to over 1,250 investment funds – also known as ‘collective investments’.
This type of account has no strings attached, in that you can invest as much or as little as you want, in any of the types of investment available. It also puts no restrictions on the liquidity of the assets meaning you can usually access your money whenever you want it.
There are no tax advantages connected to this account so it is likely you will have to pay CGT on any profits you take above your annual allowance.
Which combination might be right for you?
The accounts you use and the way you divide your investments between them can have a significant impact on the long-term performance of your portfolio. So when you consider these basic types of account, you may decide that using more than one – or even a combination of all three – will give you the best possible chance of achieving your goals.
It is important to ensure your portfolio is as tax-efficient as possible: otherwise, over the longer term, taxes will seriously erode your overall wealth. But liquidity may be a key consideration too: you don’t want to tie your money up for decades if you expect to need access to money earlier.
This is where a financial adviser can be especially useful. They can help you to decide how best to use different account types in combination, as part of an overall strategy that’s tailored to your particular needs and goals.
Finally, you should always be aware that any investment comes with risks, so your investment’s value may go down as well as up, and you may not get back what you put in.