Anyone who plans to put their money away for the medium to long term – that’s five years plus – should consider investing in the stock market. With cash returns at near-record lows, it pays to take on a bit of risk, and if you take advantage of the benefits of tax efficient wrappers, your income and gains will be free from HMRC’s grasp too.
You are allowed to squirrel away £20,000 this tax year into a stocks and shares ISA: there’s no tax on capital gains or dividends, and any withdrawals you make are also free of tax.
If you invest outside the ISA wrapper, this year, the first £2,000 of dividends are tax free and the rest are taxed at 7.5% for a basic rate taxpayer, 32.5% for a higher rate taxpayer, and 38.1% for an additional rate taxpayer.
However, there is no guarantee that the dividend allowance will stay at £2,000 – or remain at all – given that it has already been cut from £5,000 since it was introduced in 2016. But if you invest within an ISA, by contrast, all dividends will always be tax free – and there’s no tax on capital gains either.
Outside the ISA you’ll pay tax on any gains during the year that exceed your annual allowance – which this year is £12,000. After that, basic rate taxpayers will pay 10% tax, and higher and additional rate taxpayers 20% on gains.
UPDATE: See the recommended Top 5 ISA funds for growth returns in 2020 here.
What other tax efficient investments are there?
There are more tax-efficient investment vehicles available: Venture Capital Trusts (VCTs) offer 30% income tax relief on all money invested (as long as you hold them for at least five years). However, VCTs are specialist vehicles that invest either in unquoted companies or Aim stocks, which can be much riskier than established, quoted businesses. As such, they are only suitable for the most sophisticated investors, with the ability to absorb losses.
There are also specific investment objectives for which other investment vehicles offer superior benefits. If you’re aged between 18 and 40, you can put up to £4,000 a year into a Lifetime ISA (LISA) up until age 50 and get a 25% top-up from the Government on all contributions. The money will then grow tax free, and you can take a tax-free income from the age of 60. You can withdraw your money before then without paying a 25% charge if you are buying your first home.
If you are a self-employed basic-rate taxpayer, a LISA could be another option for retirement savings. However, for the vast majority of people, a pension is a better bet, especially if you are employed, because your employer has to contribute to the pension too – potentially doubling your investing power.
Instead of becoming the main vehicle for retirement, in most cases ISAs play a useful role alongside the pension, offering flexibility. They can, for example, enable you to manage how you take an income in order to remain below the higher tax threshold. Alternatively, if you phase retirement, you might want to keep contributing more than £4,000 a year to your pension, so you don’t want to want to take an income from your pension and trigger the money purchase annual allowance. If you have ISAs alongside your pension, it enables you to generate an income from those instead.
LISAs have a far less ambiguous role in saving for a first property. The government top-up offers up to £1,000 a year towards your property deposit, which far outweighs the potential gains from any other kind of savings or investments. Any prospective first-time buyer aged 18-39 who has at least a year before they intend to buy should consider a LISA. If you are too old or too young, or you want to buy sooner, you can use a Help to Buy ISA. These have a lower maximum investment and bonus, and offer less flexibility, but still offer a 25% government top up on contributions.
Another member of the ISA family offering significantly enhanced benefits is the Junior ISA. This came in the wake of the demise of the Child Trust Fund (CTF), and like the CTF offers tax-efficient investment in return for tying the money up until the child is 18. The JISA is superior in a number of ways, as it tends to offer better interest rates on cash, more investment choice, and lower charges.
Both are less flexible than investing for a child through a bare trust, because money in a trust can be cashed in at any time – as long as it is used in the best interests of the child. In many cases, money in a bare trust is also effectively tax-free, because it is taxed as belonging to the child. However, the exception to the rule is where the money is invested by parents and income on investments is £100 or more, in which case it is taxed as belonging to the parent. If there’s a risk you will breach this limit at any stage it’s well worth considering a JISA instead.
Top ISA funds for 2020
Aviva UK Listed Equity Income
Now that the political thunderstorm looks to be clearing, investor sentiment towards the UK stock market has improved. The FTSE 100 and FTSE 250 rallied following the General Election, but there are still plenty of pockets of opportunity to be found. This fund is focused on companies in the UK that pay sustainable dividends – good for income investors, but also those looking for growth as dividends reinvested can help to grow your pot faster.
The UK stock market is home to many global businesses across a number of sectors, so investing in domestic-listed stocks offers some diversification but as with any single-market fund, this should be held alongside other differentiated investments. Aviva UK Listed Equity Income
Artemis Global Income
In the past, the UK was one of just a few places you could find dividend-paying stocks. Now, income-seekers are being rewarded with a slice of the profits in the US, Asia, Europe and even Latin America. This fund invests in dividend-paying companies from across the globe, managed by a highly experienced fund manager. The fund manager invests in a mix of stocks with big dividends and those with a lower pay-out that he thinks will grow over time. There are around 100 stocks in the portfolio, mixing some of the largest companies in the world – household names – with lesser-known medium sized companies. As with any income fund, this is suitable for investors looking for income or long-term growth as reinvested dividends compound to grow your investment. Artemis Global Income
JP Morgan Emerging Markets
For ISA investors thinking long-term, who already have a well-diversified portfolio, this may be a good opportunity to add a little risk in exchange for potential future reward. Emerging markets benefit from faster growing economies, supportive demographics and a diverse array of sectors to invest in. Emerging markets are currently more attractively valued than many developed markets too, but investors should be aware that investing in these markets can be volatile. JP Morgan Emerging Markets
M&G Global Macro Bond
Already got plenty of equities? It might be time to diversify. A good portfolio should have a mix of investments from different countries and a range of asset classes. This ensures that you have different drivers of returns at different times – meaning when some investments fall others should either rise or preserve your capital. This bond fund is run by a highly experienced fund manager – one of the best fixed income investors in the business. The fund aims to benefit from currency movement which makes it different from other bond funds, and can significantly boost returns – but equally can drag on performance if the fund manager gets the call wrong. M&G Global Macro Bond
And finally, for investors who want to outsource their portfolio management, a multi-asset fund is the answer. This multi-asset fund prioritises protecting your cash in a market slump by investing in a mix of stocks, bonds, cash and gold. It aims to deliver long-term growth with less volatility than the stock market. While it may lag a rapidly rising stock market, it should make up for it in a downturn. A good starting point for new investors and cautious old-timers alike. Troy Trojan
Why save into a cash ISA?
Cash ISAs make a great deal of sense for anyone who is saving for something within the next five years or are putting money aside for emergencies. As investments can go down as well as up, for short-term goals, cash offers greater certainty. They’re also a useful place to hold the cash portion of a portfolio.
Cash ISAs are less popular than they used to be largely because of the advent of the savings allowance, which means the first £1,000 of interest earned by a basic rate taxpayer (£500 for higher rate taxpayers) is tax-free. It encouraged people to question whether cash ISAs were worth bothering with – especially because at the moment cash ISAs tend to pay marginally less interest than their equivalent savings accounts.
However, there are still good reasons for protecting your savings from tax for life. If there’s any possibility your income will rise, interest rates increase, or government policy changes and the savings allowance is threatened, sheltering your savings permanently from tax within a cash ISA is well worth considering.
Bear in mind also that ISA savings are cumulative, so over the years the sum protected from tax will really add up.
Emma Wall is head of investment analysis at Hargreaves Lansdown
Also see: ESG investing for ISAs – five top ESG funds for you to consider if you want to be an ethical investor