Since Isas were introduced in 1999 they have proved a great success, with around 20 million adults currently holding an account. Their combined holdings are worth about £600bn and 13 million people contributed last year.
The relative tax benefits of Isas have been steadily increasing in recent times, particularly for stocks and shares accounts. The usefulness of Isas is likely to increase as a consequence of both government tax policy and decisions of the Bank of England.
However, concerns have been raised by HM Revenue & Customs over the compliance record of several Isa managers. Now is therefore a good time to review how the Isa landscape is changing and the benefits these accounts offer.
Many economists believe inflation is rising because the Bank of England has been slow to raise interest rates, and that this issue will persist for some time. Savers have no control over inflation but we can choose where our savings are invested.
With the personal allowances frozen by the Chancellor, more of us will progressively be drawn to higher tax rates. The capital gains tax annual allowance is being held at £12,700 so there is a risk that inflationary capital gains outside an Isa will be caught.
The Office of Tax Simplification proposed that the CGT annual allowance should be reduced substantially. The Government has fortunately not taken up that suggestion so far but I don’t think it should be ruled out longer term.
1) Use Isas to beat the dividend tax rise
Historically a well-balanced share portfolio has proved to be one of the best hedges against inflation and it makes sense to invest within a tax free stocks and shares Isa.
Take the treatment of dividends. When Isas were introduced a basic-rate taxpayer with a personal holding received dividends at no personal tax cost, so an Isa may not have seemed particularly beneficial. The same investor must now pay dividend tax at 7.5pc, with an extra 1.25 percentage point rise applying from April.
This may not have mattered for most savers when the dividend allowance was £5,000, but at the current £2,000 it becomes an issue for anyone with a share portfolio above £60,000 or so. Higher-rate taxpayers currently pay 32.5pc on dividends outside an Isa but this will now increase to 33.75pc.
Using an Isa can be particularly helpful to shelter savings income if you or your partner are claiming child benefit and have an income between £50,000 and £60,000, where the extra tax charge can create a high marginal tax rate. The same applies for those with income between £100,000 and £125,140 where the reduction in the personal allowance creates an effective 60pc income tax rate.
2) Avoid inheritance tax by transferring your Isa
Readers will know that Isas form part of your estate for inheritance tax purposes. What you may not know is that on death your Isa can be transferred intact to your spouse or civil partner under your will.
Your spouse will be given an additional subscription allowance equal to the value of your Isa at death, known as an “additional permitted subscription”. This is on top of your existing allowance. Investments will not need to be sold and can be transferred across.
The transfer under the will not attract IHT because it is protected by the spouse exemption. The asset will then be in the estate of the surviving spouse unless they remarry and repeat the exercise.
Incidentally, since 2018 an Isa can continue to benefit from tax free growth for up to three years while the estate is being administered.
3) Protect yourself against future issues and check your provider is reputable
Last November HMRC published its review of Isa compliance following the collapse of London Capital and Finance and in response to an urgent request from the Treasury to look at “the sufficiency of checks on Isa managers and the penalties regime”.
This review included the worrying observation that some Isa managers repeatedly break the rules and pay penalties to the tax authority because it is cheaper than fixing their systemic problems.
The emphasis is to tighten the penalties that can apply to make sure that all managers follow the rules in future. HMRC recognises that voiding an Isa might be disproportionate to the severity of the breach and would primarily punish investors rather than the managers. My concern, nevertheless, is that this remedy has not been specifically ruled out.
Clearly the withdrawal of tax reliefs would be catastrophic for investors, despite them being blameless. The closing date for submissions is next week and we should expect some changes later this year. My view is that commercial pressure through disclosure offers the best solution. If my Isa manager has committed a breach I want to know about it. I would then have the opportunity to switch to a manager with a clean record.
…and a suggestion to the Chancellor
Finally I think there is a measure that the Chancellor should consider. If you have not utilised your IHT annual exemption it can be carried forward for one year. The pension annual allowance can also be carried forward, in this case for three years. It would not cost the Treasury a great deal to allow a similar carry forward of any unused Isa annual allowance.
Tax Hacks is written by Mike Warburton, previously a tax director with accountants Grant Thornton, and is published twice a month on Tuesdays. You can email Mike on firstname.lastname@example.org