How to make the most of your tax breaks and pick the right Isa
Along with fitted carpets and Volvos, investment has historically been seen as the preserve of the middle-aged and higher-earning. However, many of the recent changes in the Isa and pensions landscape have been aimed squarely at the younger generation.
In encouraging the next generation to save, the government has a hard task on its hands. According to a recent survey by the Institute of Fiscal Studies, the millennial generation - those born between the early 1980s and early 2000s - is now the poorest in Britain, while older people are getting richer.
Those aged 30-60 have seen no change in their income since the financial crisis. This is not a helpful backdrop for encouraging a savings culture.
Nevertheless, the government has launched two key initiatives aimed at younger savers: the help-to-buy Isa and the lifetime Isa. Others, such as the dividend and personal savings allowances, also appear to be aimed at smaller savers.
At the same time, some of the pension changes - restrictions on the lifetime allowance, lower tax relief on contributions for high earners - appear to be an attempt to redress the balance between old and young. Each of the new changes sees certain groups benefit more than others.
£1,000 personal savings allowance
Good for... 20-somethings
Basic-rate taxpayers can now get £1,000-worth of investment income tax-free without even declaring it on their tax return.
At current tax rates, that means that savers can hold around £100,000 in a non-Isa account paying 1 per cent without ever paying tax.
Anna Sofat, founder and managing director of Addidi Wealth, believes that this should help 20-somethings build up that much-needed emergency fund, which should be the starting point for savings. It is also supremely flexible.
That said, many 20-somethings may still want to save into tax-free cash Isas, where the rates can be marginally higher.
Savingschampion.co.uk shows that the top rate on a non-Isa savings account is currently 1.2 per cent (RCI Bank), while the top rate for an Isa is 1.5 per cent (Clydesdale).
The personal savings allowance is also handy for those who want to use their Isa allowance elsewhere - for stocks and shares, for example.
That said, the allowance falls to £500 for higher-rate taxpayers and zero for top-rate taxpayers, so it is more advantageous to younger, lower earners.
£5,000 dividend allowance
Good for... those new to the stock market (but experienced investors benefit as well)
The new dividend allowance means investors won't have to pay tax on the first £5,000 of their dividend income, no matter what non-dividend income they have. As with the personal savings allowance, this allows investors to build up quite a chunky pot without ever paying tax.
If the income currently available on FTSE 100 companies currently averages 3.75 per cent (source: Morningstar, 18 July), investors can build up a pot of over £130,000 without ever troubling the taxman.
This may also be good for those who want to dip a toe into the stock market, but would rather keep their Isa allowance for cash.
Sofat points out that those in their 20s and 30s may want to make tentative steps into the stock market: 'Even if someone is only investing £50-£100 per year, it will compound over time and, while they won't get much in the first two to three years, it will start to build momentum.'
Experienced investors with money outside an Isa will also benefit to the extent that their dividend income falls below the £5,000 limit. However, dividend tax rates rose further up the scale, so it doesn't benefit those with significant dividend income.
West says: 'Investors shouldn't neglect general accounts. Since last year, they have been able to generate £5,000 worth of dividends without incurring tax and it is worth making the most of this allowance.'
Extended Isa allowance
Good for... everyone (with £20,000 a year to set aside)
The extension of the Isa allowance from April 2017 is, without question, good news for everyone. In a low-return world, the ability to shelter more income and capital gains from tax is great.
However, those really celebrating will be those who had more than this year's £15,240 allowance to save in the first place. It is also good for those who can't contribute as much as they'd like to their pension because they are higher earners - see below.
In practice, this is likely to benefit those in the 'accumulation years' - 40- and 50-somethings - more than it will cash-strapped 20- and 30- year olds. In your 50s and 60s, the priority should be generating an income stream. With a £20,000 Isa allowance, this is relatively easily done.
NEW ISA TYPES
Good for... those buying a small house outside London, on a short time frame
Help-to-buy Isas were the government's first foray into using the popular Isa allowance to help people save for their first home; but how helpful are they?
On the plus side, if you're a first-time buyer saving for a mortgage deposit, they look pretty good. Interest rates are generous - up to 3 per cent a year - and the state will add 25 per cent free cash, up to a maximum of £3,000 added to savings of £12,000.
But there are some pretty significant drawbacks. They can only be held in cash. In theory, this makes sense because people may only have a time horizon of two to three years, not long enough to merit exposure to the stock market.
However, the housing market has historically risen quickly, and cash isn't going to help people keep pace with it.
Petronella West, head of private clients at Investment Quorum, points out that house prices in London and the South East in particular have seen significant rises and, while they may be slowing, a full collapse looks unlikely, given supply and demand issues and with borrowing very cheap.
The maximum that will attract the government bonus in a help-to-buy Isa, £12,000, is very small in this context.
She suggests that those with a longer timeframe (five years or more) might want to consider taking more risk to try and generate a higher deposit and protect against inflation, possibly through a lifetime Isa or a conventional stocks and shares Isa.
Simon Bashorun, financial planning team leader at Investec Wealth & Investment, points out that there is also zero flexibility for those who choose not to use it to buy a house. Lifetime Isas, in contrast, can also be used for retirement savings.
That said, for those who would be saving in cash anyway, who can boost their deposit from elsewhere and are absolutely sure this money will be going towards a home, help-to-buy could be a good option.
Good for... those saving for a first home, self-employed pensions
A good first question, says West, is: 'Am I saving for one to two years because I have got no reserves? Or am I saving specifically to buy a house? This matters. If you're buying a house, a lifetime Isa is the most efficient way to do it.'
Lifetime Isas beat help-to-buy Isas on a number of fronts. They can be put into stocks and shares; they can be used for pension savings should you not be able to buy a house; and you can get a lot more in - up to £4,000 every year, which the government will top up with up to £1,000 per year.
The money has to be used for either a first home (up to £450,000) or for retirement at age 60 or over. If savers choose to do anything else, they lose the government's contribution and any growth in that contribution, and they pay a 5 per cent surcharge.
This is quite restrictive and leaves investors relatively few options if they change their mind. Equally, most people will be better off with their company-run pension scheme (through auto-enrolment), to which their employer makes a contribution.
Tom McPhail, head of pensions research at Hargreaves Lansdown, suggests that the key users for the lifetime Isa are likely to be:
- Those saving for retirement who won't get the benefit of an employer pension contribution, usually the self-employed
- Those who haven't yet bought their first house and are likely to want to use their savings to do so
- Those who have already secured their maximum employer pension contribution through a workplace scheme, and want to save more on top
Innovative finance Isa
Good for... those on the hunt for income and/or diversification
The government has expanded the range of investments that may be held in an Isa. The innovative finance Isa was launched to house peer-to-peer investments and other new forms of lending.
The move to allow Aim stocks to be held in conventional stocks and shares Isas also expanded the scope for investors.
These innovations have only a niche appeal. Peer-to-peer lending can allow investors to diversify their income when income is relatively scarce, but it is a relatively new investment option with little track record to date.
The FTSE Aim index, meanwhile, has had a relatively dismal five years - down more than 10 per cent at a time when the FTSE 100 is up over 10 per cent. Investors may not be leaping on board. Nevertheless, it may help those with an interest in smaller company investing.
CHANGES TO THE ISA STRUCTURE
Good for... oldies
There have also been widely overlooked but important changes to the inheritance tax treatment of Isas. Isa tax benefits can now be passed on to a spouse after death.
The mechanism is clunky, but it is a boost for the surviving spouses of the 150,000 married Isa savers who die each year, meaning they can continue to receive a tax-free income from a spouse's pot.
Good for... the Exchequer
Lifetime Isas were thought to be a starter-for-ten in the government's move to get rid of pensions and shift towards a 401k-style system.
However, George Osborne didn't in the end abandon pensions; and now he's headed off to the backbenches and his successor has bigger fish to fry.
Nevertheless, he did cut down the lifetime allowance, restricting the amount that can be saved into a pension, and knock back pension tax benefits for high earners.
From the start of this tax year people with an income of over £150,000 will have a lower annual allowance limit than the standard £40,000.
It is reduced by £1 for every £2 of income above this limit, to a maximum reduction of £30,000 (leaving just £10,000 of contributions allowable for tax relief).
DON'T FORGET - OLD, BUT STILL USEFUL
Traditional stocks and shares Isas
The income is tax-free, the gains are tax-free, and investors can put anything they like in them and take it out whenever they like. Let's not forget these are still the ultimate tax-incentivised savings vehicle.
Sofat says: 'If you are maxed out on both Isas and pensions, you might start looking at an investment bond wrapper. These have onshore and offshore versions and preferential tax treatment.
'They are only suitable for larger cash sums - £50-£100,000 - but investors can take some income out and it is possible to use them for school fees.'
Bashorun concludes that by varying the wrappers used, investors can shelter a relatively large chunk of their savings and investment income from tax.
'There is a personal allowance, the personal savings and dividend allowances, the capital gains tax limit. If you have a diversity of "pots", you can create a relatively high tax-free income.'
This argues for holding investments across wrappers to make the most of all the individual allowances.