Ask the Expert

Ask the Expert – March

Independent expert Harvey Jones helps a reader to understand how to make the most of their tax-free allowance

“How do I make the most of my tax-free allowance?”

Making a decent return on savings and investments can be tricky in the current market, even before the taxman takes his share of your gains. But happily, you can invest thousands of pounds every year without paying a penny in income or capital gains tax.

All about ISAs

Every UK adult is eligible for an Individual Savings Account, otherwise known as an ISA. If you are a taxpayer and can afford to set a little aside, make sure you put it in an ISA. ISA savings are worth more to you than those in a standard savings account as you won’t pay tax on the interest earned on the funds.

An ISA is a tax-free wrapper that you place around a wide range of savings and investments, allowing you to build up interest on your savings free of tax. In the current tax year, you can tuck away up to £11,280 into ISAs and this will increase by £240 next month when the new tax year begins.

ISA savings are worth more to you than those in a standard savings account

Pretty much every bank and building society offers an ISA in some shape or form, as do most fund managers. Your ISA allowance comes in two parts: a Cash ISA and a Stocks and Shares ISA. If you choose to, you can save the whole of your allowance into a Stocks and Shares ISA, or you can split it between the two. But you can’t save more than £5,640 into a Cash ISA. This will go up by £120 for the 2013/14 tax year.

Whether you split your allowance 50/50 or tip the scales in favour of Stocks and Shares is up to you. You can even buy individual stocks and shares, and put them in an ISA yourself. So how do you make your choice?

Stash the cash

The attraction of cash is that it is relatively safe. While the stock market could theoretically fall by 20 per cent tomorrow, your cash savings won’t fluctuate in value, provided you leave them alone. The downside is that interest rates remain low in the current climate, so you’ll have to shop around to find an account to provide an inflation-beating return on your money.

The attraction of cash is that it is relatively safe

However, you won’t pay income tax on the interest you earn. In a normal savings account, basic rate taxpayers will lose 20 per cent of the interest gained, while higher rate taxpayers lose 40 per cent. In ISAs, you will lose none of the interest earned.

ISAs replaced TESSAs in 1999, so if you have been making full use of your annual Cash ISA allowance, you could have many tens of thousands of pounds stashed away by now, saving yourself a great deal in tax you would have otherwise paid.

It is worth checking the rate you are currently getting on your Cash ISAs
It is worth checking the rate you are currently getting on your Cash ISAs. The interest rate on many historical accounts is under one per cent. And you are free to transfer these funds to a higher-paying product with any bank or building society. Make sure you speak to your ISA provider. They’ll show you how the funds can be transferred without affecting your tax benefit on them.

Share your gains?

If you are comfortable taking a greater risk with some of your money in the hope of generating a higher return, consider a Stocks and Shares ISA. Stock markets can be volatile, but over the long-term they should outperform cash.

To reduce risk, only invest money that you don’t expect to need for the next five to 10 years. That gives you time to overcome any short-term market volatility. To spread the risk you could also divide your money between different funds, markets and regions. You could start by taking out a low-cost tracker fund that mirrors the fortunes of an index such as the FTSE 100 or FTSE All-Share. If the index rises, so will the value of your fund. If it falls, your fund will follow.

Alternatively, you could invest in an actively-managed fund. These employ specialist managers in a bid to beat the index, but their track record can be hit and miss. Some managers do well, year after year. Others regularly underperform. Actively-managed funds have higher charges than trackers, which also eats away at the value of your investments. There are thousands of funds to choose from, so you may need to take independent financial advice to find the right ones for you.

ISAs aren’t the only way to save tax effectively

If you fancy having a go at picking your own stocks and shares, you can do that tax efficiently inside your ISA allowance. Choosing stocks and shares can be great fun, provided you understand the risks involved. The stock market is volatile and the value of your funds can go up as well as down. You could learn to be your own fund manager over time, but be prepared to lose as much money as you could make in the early years.

ISAs aren’t the only way to save tax effectively. You can also claim tax relief on any contributions you make into a pension. The amount you can claim depends on your tax bracket. If you are a basic rate taxpayer, you can claim 20 per cent tax relief, while a higher-rate taxpayer can claim 40 per cent.

Each year, you can pay up to 100 per cent of your annual earnings into a personal pension plan or stakeholder pension, up to the current annual maximum of £50,000. If you don’t earn enough to pay tax, you can still make contributions up to £3,600 a year, which includes 20 per cent tax relief.

The tax benefits of ISAs and pensions are complementary. You don’t earn any tax relief on your ISA contributions, but the income and growth is free of tax. You do get tax relief on pension contributions, but the income you draw is taxable. You can also take 25 per cent of your pension fund at retirement as a tax-free lump sum. A combination of both is therefore ideal.

Don’t forget about the kids

ISAs aren’t just for grown-ups. Children can have one as well. All under 18s in the UK can have a Junior ISA, unless they already have its predecessor — the child trust fund. Up to £3,600 a year can be invested into a Junior ISA on a child’s behalf. The money grows free of tax until the child turns 18, when it can be withdrawn by them. This could be a useful pot to draw on for university tuition fees, a first car or a deposit on a home. And of course at 18 the funds can be transferred into an adult ISA to keep earning interest.

ISAs aren’t just for grown-ups. Children can have one as well

Again, Junior ISAs can include cash or stocks and shares investments. Many people are reluctant to invest children’s money in the stock market, but kids do have one advantage over grown-ups. Time is on their side. Over 18 years, stocks and shares may deliver a much better return than cash. But this is never guaranteed.

Your tax-free allowance is available on a ‘use it or lose it’ basis. If you don’t use each year’s allowance before 5 April, you have lost it for good. But there’s always a new allowance each year and this now rises in line with inflation. That is good news for you, and bad news for the taxman, so make the most of it.

And that’s not all

There are other ways to save tax-efficiently, including some low-risk government backed savings. You might also consider a savings bond from a friendly society. Sometimes called children’s bonds, they allow you to save £25 a month, or an annual lump sum of £270, and take the returns free of tax. Check charges however, because they can be relatively steep.

If you’re not a taxpayer, make sure you don’t accidentally pay tax on your savings. Tax at 20 per cent is automatically taken off any interest you earn in a standard deposit account. To receive interest gross, complete HMRC’s form R85 and hand it to your bank or building society.

Disclaimer

Disclaimer

  • If you have a general financial query or dilemma unrelated to a specific financial services provider, email Harvey at asktheexpert@virginmoney.com.
  • Harvey regrets that he cannot answer your questions individually. These are his personal views and not those of Virgin Money. Nothing in the article constitutes legal, financial or other professional advice.
  • If you have a specific financial concern, you should always seek your own professional financial advice.
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