Invest Now to Benefit from your ISA Tax Allowances
Updated: Mar 13
As the ISA investment deadline of midnight on 5 April 2021 fast approaches, investment management consultant MATTHEW FEARGRIEVE explains what action you must take to benefit from the £40,000 tax savings allowance for your pension pot.
It comes around quickly, this time of year, doesn't it? I don't mean British Springtime, but something that perhaps doesn't exactly put a spring in your step. I mean, of course, the ISA investment deadline.
This year, the deadline is midnight on 5 April. You have until then to make sure that you make the most of your £20,000 tax allowance (£40,000 if you're a couple).
Like many savers and investors, you will be pondering which investment funds to buy for your ISA portfolio this time around. I help you with that question in my separate investing blog here, but right now I want to set out the formal steps you need to take to make sure you do what you need to do in good time before the deadline on 5 April. So read on.
What is an ISA?
An ISA is an Individual Savings Account. It works like a normal savings account, except you don’t pay any UK income or capital gains tax on any income (ie, profit, or investment returns) it produces. Different types of ISAs offer various ways to save and invest.
A Cash ISA is for saving cash only, without investing.
A Stocks and Shares ISA is, as its name suggests, an account the value of which is invested (directly) in shares of UK and international companies and/or (indirectly) in investment funds whose managers pick shares for you.
As well as setting up an ISA for yourself, you can also do so for under-18s: this is called a Junior ISA.
What is the so-called "ISA allowance"?
Each tax year (6 April to 5 April), you are allowed a limited amount of money that you can put in an ISA. This limit is called the ISA allowance. In the 2020/2021 tax year that we are concerned with right now - which ends on 5 April - the allowance is £20,000. The deadline for adding money to your ISA each tax year is midnight 5 April. So you have until that time to set up and/or invest your ISA for the current tax year, if you haven't already done so. If you miss this deadline, you miss being able to take advantage of your ISA allowance.
You can only add money to one ISA of each type in a tax year.
How does the ISA allowance work?
You can put up to £20,000 in respect of the current tax year (ending midnight of 5 April) into your ISA and you won’t pay any income tax or capital gains tax on any income (profit) that your investments generate.
Note that you don’t have to have the full £20,000 on the hip to have an ISA. You can save as little as £25 a month, or invest occasional lump sums of upwards of £1,000, as and when you are able (or feel like it!).
Can you tell me more about the ISA allowance?
There are three key things to be aware of:
the standard annual contribution allowance is £40,000 for most people;
you can carry forward any unused personal tax allowances from the three previous tax years; and
if you earn over £200,000, tapered annual allowances will apply.
The tax relief your ISA gives you depends on how much you earn, what rate of Income Tax you pay and the type of pension you have. In many cases it’s all handled by your pension provider. However, if you pay tax at a rate above the basic rate of 20% and have contributions going into a personal pension, you may need to claim any extra tax relief to which you’re entitled.
Unfortunately, taxation depends on each person's individual financial and personal circumstances, and you should always remember this when reading articles like this about financial products! But, basically, you can get tax relief on any contributions you make towards your pension, so a £1 contribution actually only costs you 80p, assuming you’re a basic-rate taxpayer.
Remember that the tax relief your ISA gives you depends on how much you earn, what rate of Income Tax you pay and the type of pension you have. In many cases it’s all handled by your pension provider. However, if you pay tax at a rate above the basic rate of 20% and have contributions going into a personal pension, you may need to claim any extra tax relief to which you’re entitled.
What about Junior ISAs?
The Junior ISA allowance for the current tax year (same deadline, midnight on 5 April) is £9,000. Once your child reaches 18, they can access the funds in the ISA. Have fun explaining to them that they have to wait to get their hands on it!
Like your own ISA, any income (profit) earned in a Junior ISA is exempt from the normal income and capital gains taxes, so every penny saved and earned is theirs.
How do I pick an ISA provider?
Just like a bank account, you need a service provider to provide you with an ISA account.
Call as many providers (just google "ISA providers") as you like. But, do call tow or three at a minimum. Ring them and ask them to explain the process. They will be only too happy to do this.
But remember - their goal is to sell you their product, so don't feel pressured or obliged to go with them. Shop around. Don't be shy about telling them that this is what you are doing. They will understand. Each ISA provider has different fees for providing you with an account service, so shopping around for the lowest fees is important.
What are the basic steps for setting up an ISA account?
Again, any ISA provider will be happy to explain the steps by phone or online, and on a no-obligation basis.
But, to give you some idea, here are the basic actions involved:
Step 1: find an ISA provider. This, ultimately, is a matter of googling "ISA providers". The key names that this search will throw up will be Fidelity and Hargreaves Lansdown. You will also find the usual comparison websites to assist you.
Step 2: choose a provider an set up an ISA account. Just click through the steps that your chosen provider gives you online. Remember, all an ISA is, is an account. So this is a bit like setting up a bank account, where you will send money. You will probably need:
National Insurance number
Debit card details (for a single payment)
Bank or building society details (if you’re planning on setting up a regular savings plan)
Step 3: remember, you don't have to pick your investments before 5 April. Just make sure that you have an ISA account set up by then, with money in it.
Step 4: decide how much to pay in. You are currently entitled to tax relief on pension contributions up to the total amount of your relevant earnings in a year, or £3,600 gross (£2,880 net), whichever is higher. However, there is an upper limit known as the annual allowance which is £40,000 for the 2020/21 tax year. Be aware that exceeding this limit may trigger a tax charge, which will claw back any excess tax relief given at source.
Remember, even if you don't have any earnings, and therefore don't pay tax, you can still pay £2,880 into a pension plan and have it topped up to make a total contribution £3,600.
Also remember that the annual limit you can receive tax relief on for your pension contributions includes any contributions to a pension made by an employer. If you exceed the annual allowance across all your pension savings, not per scheme, you may have to pay a tax charge on the excess known as ‘the annual allowance charge’. The rate of this annual allowance charge generally will be linked to the highest rate of Income Tax you pay.
Finally, and most importantly...
A key thing for novice investors to be aware of is that investing in a pension fund like an ISA, which is allocated to a portfolio of investment funds (see here for an explanation of an ISA portfolio), is very different from putting your cash in a bank account.
An investment is a essentially an educated gamble: the value of your investment in the stock market can fluctuate. This means that you might not get back the same amount of money that you initially put in.
Remember also that it is typically recommended that your money stays invested for at least five years. This is because the longer you invest, the longer you have to ride out any short-term fluctuations in the value of the market (of which there are many, every week!).
Want to know more?
For information on how to choose investments for your Stocks and Shares ISA, click here.
For information on the Stamp Duty Holiday and House Prices, click here.
Important: this article does not constitute professional investment advice which is intended to be relied upon, nor should it be relied upon when making investment decisions, for which you should always consult your own financial adviser, who can give you professional advice that is appropriate to your individual circumstances.