Why Using Your ISA Allowance Every Year Is So Important

We are now less than 2 months away from a new tax year in the UK.  With that new tax year comes a new ISA (Individual Savings Account) allowance.  The Investing Wisely portion of my Low Charge Strategy requires me to continually work at minimising the tax paid to HM Revenue & Customs  which is partly achieved by maximising my ISA contributions and coming as close to the full ISA allowance every year as possible. 

Before we review why maximising contributions and preferably using the full ISA allowance is so important let’s first review the basics of ISA’s:

• An ISA is nothing more than a wrapper that surrounds purchased assets such as cash and shares.  Its primary purchase is to shield you from taxation.
• There are two types of ISA.  The first is a Cash ISA where you can contribute up to £5,640 in the current 2012/13 financial year.  In the 2013/14 financial year the allowance will rise to £5,760.  The second is a Stocks and Shares (S&S) ISA into which you can contribute £11,280 less any contribution made into a Cash ISA this financial year.  In 2013/14 the S&S ISA allowance will rise to £11,520.
• Contribute refers to the total amount of money you can pay into the accounts each year.  For example it is allowable to contribute £11,280 into a S&S ISA and then withdraw £3,000.  What isn’t allowed is to then add that £3,000 back into the ISA within the same tax year.
• Current government policy is that the annual ISA subscription limit will be increased annually by the Consumer Prices Index (CPI). The increased limit will then be rounded to enable punters to make regular monthly payments in round terms. If the CPI is negative then limit will not be reduced but will be left unchanged.
• Any savings in a Cash ISA can be converted to a S&S ISA but you can’t convert a S&S ISA into a Cash ISA.
• You don’t pay any tax on interest received with a Cash ISA.
• You don’t pay any tax on dividends received within a S&S ISA.  If you’re a 20% (basic rate) tax payer then in theory the ISA offers no advantage because 20% tax payers don’t pay tax on dividends.  If you’re a 40% (higher rate) or 45% (additional rate) tax payer then you get a big advantage because if you’re saving outside of an ISA your effective tax rate on dividends are 25% and 30.55% respectively after allowing for the dividend tax credit.  ISA’s therefore offer higher and additional rate tax payers a significant advantage however I also believe that basic rate taxpayers should also take advantage.  The reason is because you never know when you will be a higher rate taxpayer plus you also never know when government will start to apply tax to dividends received by basic rate taxpayers. 
• You don’t pay Capital Gains Tax within a S&S ISA.  If you’re outside of the ISA wrapper then UK taxpayers receive an Annual Exempt Amount (£10,600 in 2012/13) however after this then you’re up for tax at 18% or 28% depending on your taxable income.  So ISA’s save basic rate, higher rate and additional rate taxpayer’s tax.  You may think that you can invest outside of an ISA and keep capital gains tax within your annual exempt amount by controlling when you sell but remember corporate events outside of your control like takeovers and share swaps can trigger capital gains tax events.  Within the ISA you have nothing to worry about.
• A time advantage is that you don’t need to keep records for tax reasons and because you can ignore anything within an ISA for tax reasons then filling in your annual tax return is greatly simplified. 
• It is a use it or lose it allowance.  So if you only contribute £10,000 to a S&S ISA this year then that’s it. You never get another chance to contribute that £1,280 of unused allowance.  It is lost forever. 

The last point is critical and shouldn’t be underestimated.  It is a mistake I have made and which is now impossible to rectify.  I was naive and for a number of years never even considered ISA’s.  Then when I did eventually understand a little about them I thought I’m just a basic rate taxpayer so they won’t help me.  Roll on a few years and hard work resulting in a few promotions plus bracket creep (inflation pushing income into higher tax brackets) has resulted in me becoming a higher rate taxpayer.  It’s a mistake that is now impossible to rectify because I can’t roll back the clock.  The vast majority of my savings will be used for my Early Retirement (some will be used to buy a home when value returns) meaning that I will possibly be paying for that mistake for the rest of my life.

Ignore Price Fluctuation - Focus on Yield

I’d like to again welcome back John Hulton.  John claims to not be a financial guru, stockbroker or financial journalist, but just an average bloke who has managed to find a way through the minefields of personal finance and develop a system that works for him and, which could be helpful for other people.  He has already retired from full time work which puts him at the end game of what this Site is about – Save Hard, Invest Wisely, Retire Early.  So while John is not a financial expert his approach has given him what many of us are chasing.  I hope you again enjoy his thoughts.

The FTSE 100 got off to a flying start in 2013, the best January rise since 1989!  The markets rose above 6,300, a price last seen prior to the start of the sovereign debt crisis in 2008.

How long this surge will continue nobody can know.  Is it a temporary spike or is it a sign that the economies around the world are starting to see signs of real recovery?  There will be much speculation in the media and on the discussion boards.

At one time, earlier in my investing career, I would probably have been thinking about selling some of the shares which had risen strongly.  I would be trying to second-guess the market - there is no justification for this rise - all the problems of systemic debt in the major industrialised countries have not suddenly disappeared - the markets will soon fall back towards 5,000 and I will keep my powder dry and pick up a few bargains later in the year.

I say ‘at one time’ but I’m sure there’s still a bit of me that thinks the same way now.  However, the emotional factors which underlie that process are basically twofold - fear and greed.  Fear the markets may suddenly swing down as quickly as they have risen and I will lose all the double digit gains on my portfolio - and the greed of selling high and buying low during the next downturn.  These two bedfellows are always present but need to be understood and neutralised if you wish to invest for the long term.

After many years as a private investor, I am gradually learning to regard these market swings and share price fluctuations with an attitude of mildly detached interest.  I really don’t get over-excited when markets rise and equally, I don’t become wracked with fear when markets are falling.  As an income investor, it will probably suit me when markets are in decline as it will throw up many more opportunities for a decent yield.

On a day to day basis, most investors will probably be following share prices because this is where all the action is.  Profits are made on the markets by buying at a low price and selling at a high price, right?  Wrong!  Over the longer term, up to 90% of the total return on your portfolio will be derived from dividends - growth of dividends and especially the reinvesting of dividends.

The FTSE 100 Cyclically Adjusted PE Ratio (FTSE 100 CAPE or PE10) – February 2013 Update

This is the Retirement Investing Today monthly update for the FTSE 100 Cyclically Adjusted PE (FTSE 100 CAPE).  Last month’s update can be found here.

As always before we look at the CAPE let us first look at other key FTSE 100 metrics:

• The FTSE 100 Price is currently 6,338 which is a gain of 5.2% on the 01 January 2013 Price of 6,027 and 9.5% above the 01 February 2012 Price of 5,791.
• The FTSE 100 Dividend Yield is currently 3.47% which is down against the 01 January 2013 yield of 3.64%.
• The FTSE 100 Price to Earnings (P/E) Ratio is currently 12.96.  
• The Price and the P/E Ratio allows us to calculate the FTSE 100 As Reported Earnings (which are the last reported year’s earnings and are made up of the sum of the latest two half years earnings) as 489.  They are down 4.6% month on month and down 11.7% year on year.  The Earnings Yield is therefore 7.7%.

So we find ourselves in an interesting situation.  Nominal Earnings are falling and have been consistently since October 2011’s Earnings of 628 yet Prices are rising.

The first chart below provides a historic view of the Real (CPI adjusted) FTSE 100 Price and the Real FTSE 100 P/E.  Look at the trend line of the Real Price.  After you strip out the effects of inflation the perceived market value is doing not much more than oscillating above and below a flat line which we are now sitting on.  The second chart provides a historic view of the Real Earnings along with a rolling Real 10 Year Earnings Average for the FTSE 100.

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UK, US, Australian + the PIGS Government 10 Year Government Bond Yields – February 2012 update

 

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I haven’t published these datasets for 20 months now because as far as the UK is concerned it’s really been status quo.  The UK Government have continued to run a budget deficit that isn’t sustainable.  There isn’t any of the promised austerity because government spending is actually rising.  This combined has resulted in the UK National Debt reaching around £1.13 trillion today.  That’s £18,021 of Debt for every man, woman and child in the UK.  Less than half of the population work in the UK, 29.17 million people working against a population of 62.64 million, so comparing the debt to this group means a debt of £38,699 for every worker. 

Government forecasts project the debt continuing to grow quickly with it reaching £1.5 trillion by 2016.  Meanwhile in parallel the Bank of England has “bought” £375 billion (33%) of that debt through the Quantitative Easing (QE) programme.  This has had the effect of forcing UK bond yields down to historic lows when under the scenario described in the first paragraph yields should have risen which would have forced the government to take action rather than masking the problem.  Now it’s important to remember that for bonds already in circulation that as yields fall prices rise and that’s what we’ve been seeing happening for a number of years now.  It is however important to remember that the opposite can also happen.  Should that happen not only would the cost of borrowing for the Government rise but also other debts like mortgages would also rise.  That would reduce affordability and would in my opinion reduce house prices (and other asset prices) helping the value argument here.  Instead of asset price deflation we’re seeing just about every asset type either holding or increasing in nominal value including housing, shares and hard assets like gold which to me seems to be making the problem we have even worse.  

I’m therefore watching government debt yields closely and what its showing is that since August 2012 those yields have been rising despite the Bank of England announcing another £50 billion of QE in July 2012.  This is not showing in mortgage rates yet because the Treasury and Bank of England are distorting the market independently there with the Funding for Lending Scheme. 

UK Savings Account Interest Rates – February 2013 Update

The UK Treasury and Bank of England’s £80 billion (or £1,277 for every man, woman and child in the UK) Funding for Lending Scheme continues to hurt savers.  The banks currently have no need to borrow money from us savers when they can go directly to the Bank of England for a nice low rate of 0.25% per annum providing they meet a few T&C’s.

Money Saving Expert now tells us that if you are in the market for an easy access savings account you can get an interest rate of 2% AER with Derbyshire.  Forget to switch after 31 March 2014 to the next bank or building society offering the highest interest rate at that time and that becomes 0.5%.  Last month you could get 2.35% on accounts offering a bonus for a fixed period of time and back in June 2012 you could get 3.2% AER variable with Santander reducing to 0.5% after 12 months.  So in less than 12 months the best rates being paid have fallen by more than a third.

Choose to go for a no nonsense easy access savings account (always my preferred option) that available interest rate is also 2% today from Virgin.  Last month the best buy was 2.3% AER with West Bromwich Building Society.  Back in June 2012 the best rate was 2.75% AER variable with Aldermore.

I must note that I’ve left the Santander 123 current account out of the analysis even though it’s currently paying 3% AER.  I have no time for this sort of account.  To me it’s made deliberately complicated and I don’t believe the average punter would have a hope of calculating whether this account is the best for them.  It pays the 3% only on balances between £3,000 and £20,000, requires a minimum deposit of £500 per  month, takes a £2 per month fee (remember you’ll pay tax on the 3% but won’t be able to claim against the £2) plus in the circles I move I hear of the poor customer service that Santander offers.  I can’t help but feel somewhere in the small print I’m bound to lose out against a simple no nonsense account.  If somebody is having success with this account please do comment below as I’m sure many readers (I know I certainly would) would like to know if you are seeing success.