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.

Let me demonstrate with an example showing just how important it is to maximise your contributions every year.

I want to make it as real world as possible and so I need to make a few assumptions:

• Average Bob is a higher rate taxpayer who is investing in a FTSE100 tracker outside of an ISA wrapper.
• Average Joe is also a higher rate taxpayer and is also investing in a FTSE100 tracker.  The difference is that Joe is buying his investment within a Stocks and Shares ISA wrapper.
• They are both buying the HSBCs FTSE100 Index Fund which has an ongoing charges figure (OCF) of 0.27%.
• The calculation will be done in real (inflation adjusted) terms.  This means the end results can be compared directly to the value of a £ today.  The inflation figure used will be 2.28% which has been the annualised change in the CPI over the last 20 years.
• Both Average Joe and Average Bob save £11,280 every year in real terms.  They invest this full amount on the first possible day of every new ISA year.
• Over the last 20 years the nominal annualised gain in the FTSE 100 Price has been 4.08%.  The annual real capital gain figure for the FTSE 100 used will therefore be 1.8% (4.08% - CPI).
• Unfortunately my FTSE100 dataset only has average dividends going back 6 years.  The average dividend over this period has been 3.63% and so this is the figure used.  This means that after HSBC deducts its OCF that Joe and Bob are getting 3.36% annually in dividends.  Bob and Joe are going to using this fund as part of their overall plan for retirement. They therefore allow all dividends to be reinvested.

Plugging all of these assumptions into an Excel spreadsheet yields a very interesting result.  Remember the only difference between the Joe and Bob is that Joe is within the ISA wrapper.  Roll forward 20 years and Bob has a very significant asset worth £362,300 in today’s £’s.  Joe on the other hand has £398,957 which is an increase of some £36,657 over Bob.  If both then entered retirement as basic rate taxpayers  and both chose to use the 4% rule then that £36,657 would result in Joe receiving  additional annual Gross Earnings of £1,367 (£36,657 x (4%-OCR)) for the rest of his life.  A not insignificant amount.  If they both remained higher rate taxpayers in retirement then the benefit would be even greater for Joe because he would continue to not be taxed on his dividends forever.

You have less than 2 months to go before this year’s ISA allowance runs out.  Make the most of it.

As always DYOR.