When these tax-free accounts might be useful
Just because you can use an ISA for savings and investments, it doesn’t necessarily mean you should. Find out how to decide if you need an ISA in 2024.
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What’s the point of an ISA?
The whole point of an ISA (or Individual Savings Account) is that any money you make from cash within one is tax-free. This continues year after year – once the money is in an ISA it’s protected.
So if you had £5,000 earning 5%, you’d get to keep all of the £250 you’d make, rather than lose 20%, 40% or even 45% to the taxman. The same goes for any dividends issued from investments, or gains (i.e. profit) made from selling shares.
Tax-free sounds good, right? Well, an ISA isn’t the only way to avoid tax on interest earned or gains on investments. There are different allowances on savings, dividends and gains, and you can also save tax-free in Premium Bonds.
These have been enough for most savers and investors in recent years – an ISA just hasn’t been that important. However, things are changing that will impact those allowances.
First though, a quick reminder of the different ISAs and how they work.
Key ISA rules
- There are four types of ISA – Cash, Stocks & Shares, Lifetime and Innovative Finance
- You can pay into one of each type in a financial year
- You can now pay into as many of each type as you want
- There’s a combined limit of £20,000 that you can put into them each year
You can read more on how ISAs work in our full guide.
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Pressure on tax-free savings allowances
The Personal Savings Allowance hasn’t changed, but a couple of factors could impact when you start paying tax on interest earned outside an ISA.
Higher interest rates
The Personal Savings Allowance (PSA) allows basic rate taxpayers to earn £1,000 of interest tax-free every year, even if it’s outside of a Cash ISA (in fact earnings from an ISA don’t count towards the PSA). Higher rate taxpayers get £500 a year, while there’s nothing for Additional rate taxpayers.
With low interest rates across the board until recently it’s meant most savers wouldn’t need to bother with an ISA for cash, and instead could focus on the highest paying account.
But for the last year there have been easy-access accounts past 5% and regular savers hitting 5% to 7%. Though these are falling down again, those with decent yet not massive sums could well breach their allowance.
And if you are fixing for a year or more, you’ll often get all the interest at once when the term ends, rather than monthly.
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Frozen tax bands
The 20% and 40% tax bands are being frozen until 2028. That means those who are close to those current levels could get pushed into the next tax band with each pay increase or promotion.
And once you earn £50,270 a year you lose half your PSA. Combined with increased interest rates that £500 could be quite easy to fill.
Meanwhile, the income threshold before you pay 45% tax dropped from £150,000 to £125,140 a year last year. This means those who earn above this new level will no longer receive a £500 PSA, so they’ll pay 45% tax on all the interest they earn.
Changes to tax-free investing allowances
The tax rates on money you make from investing aren’t changing, but the allowances that give you some tax-free profit outside of an ISA have recently been cut.
Dividend Allowance cuts
Some shares you’ve invested outside of an ISA might pay out dividends throughout the year, effectively bonus payouts, usually if the company has done well. You’re taxed on this, but receive a Dividend Allowance of £500 that is tax-free regardless of your tax rate.
This allowance has reduced from £2,000 just 13 months ago:
- April 2023 – cut to £1,000 a year
- April 2024 – cut to £500 a year
If you have a lot of shares that issue dividends, or perhaps you receive them from a limited company, this reduction will mean you’ll be more likely to pay tax at your marginal rate on any dividends paid outside an ISA.
Capital Gains Tax Allowance cuts
Cut over the same period is the tax-free allowance for Capital Gains. Again this is for shares that aren’t in an ISA (though obviously you can also make gains on other sales like second properties or expensive art).
The allowance is currently £3,000. That’s dramatically lower than before April 2023:
- April 2023 – cut to £6,000 a year
- April 2024 – cut to £3,00 a year
£3,000 might be enough for investors who make a profit when selling shares, but over time it’s more likely you’ll see gains that go past this.
One note here is that you can combine allowances as a couple, effectively doubling how much is tax-free.
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The best way to use your ISA allowance
This will obviously vary for everyone as you’ll all have different savings, investments and goals. I’m ignoring Lifetime ISAs here, though they are worth considering in the mix if you are hoping to buy a first home.
It’s worth just remembering that for most people to save or invest £20,000 in a year is quite unlikely. So you’ll probably have enough of your annual allowance to pay into a mix of different ISAs.
If you’ve got investments
If you are an investor, then there’s a chance you’re going to pay more tax over time as your profits grow when that’s outside an ISA.
For new money, it makes sense to put it into a stocks and shares ISA rather than a General Investment Account (GIA) – assuming you aren’t already doing this.
When it comes to existing money saved in a UK GIA you might want to transfer those stocks and shares into an ISA via something called ‘Bed and ISA’. This sells your shares, and buys them again in an ISA, though there could be fees and the value could change while this is happening.
You’ll pay tax on gains outside of the capital gains tax allowance when you do this, so if you have substantial amounts invested, only move over as much as fits within that – though of course you’ll also be restricted to £20,000 each financial year.
If you’re worried about your Personal Savings Allowance
For those earning less than £50,270 a year with a few hundred or a few thousand in savings, even putting them in the highest paying accounts are unlikely to go past their PSA. So you probably don’t need to worry and should just find the best rate out there.
But under these circumstances apply to you, or you think they could, then an ISA might be worth it:
- if you are a higher or additional rate taxpayer
- if you have large sums earning decent interest rates
- if you have a long-term fixed account paying at the end
For these, you need to work out what your real interest rate return will be after tax is deducted outside an ISA to see which one wins.
Remember, you only need to worry about an ISA for interest earned above the PSA, so you can still find the best rate outside an ISA for the first amount of cash.
And you can also use Premium Bonds, while low earners also get access to the Starting Rate of Savings.
If you want to protect against future rule changes
Of course, these are the current rules. If there were to change – perhaps the PSA would be scrapped or the ISA allowance reduced – then there’s a risk that more money outside an ISA would be subject to tax on profits.
So you could lock in as much as you can afford this financial year, protecting that money not just in 2022/23, but each year after.
And even if you’re mainly saving in cash right now, putting it in an ISA now can help you if you want to invest large sums in a few years as you can use it to buy shares in a Stocks and Shares ISA without using any of that year’s allowance.
A little know factor for lower earners/income people with larger sums earning interest is the Starting rate for savings. Correct me if I’m wrong, but you can use your personal tax allowance against savings. Then beyond your personal allowance you get another 5k starting rate savings and your personal saving allowance on top if you qualify.
Effectively if you are a basic rate tax payer with a personal allowance of £12570 and hypothetically earnt £12570 in earning/wages you could earn an additional 5K interest on saving in a tax year and pay no tax. Also, you could earn another 1K personal savings allowance, tax free.
https://www.gov.uk/apply-tax-free-interest-on-savings
Absolutely correct Andrew.
I am amazed this is rarely mentioned.