Stocks and Shares ISA vs Cash ISA: What Do You Need to Know?
Hello and welcome to the Tax-Free Investing Blog with me, Chris Bourne! I’m a qualified financial planner based here in the UK. I specialise in all things wealth management, retirement planning and tax planning. My goal is to bring you top tips for tax free investing to help you reach financial freedom. If you want to see other tips, make sure you check out my other blog posts here, or head over to my YouTube Channel for video versions!
Today we’re talking Stocks and Shares ISA vs Cash ISA. This is the blog you are looking for if you are unsure which is the best ISA for you and why. It will also steer you down the right path to avoid making common ISA mistakes I see all the time.
So what is it? The biggest ISA mistake I see people make is wasting their ISA allowance by opening a Cash ISA. In most cases, they could get their interest paid tax free anyway without using the ISA at all… So keep reading to find out how!
Stocks and Shares ISA vs Cash ISA: What Do You Need to Know?
If you want a recap, last week’s post was detailed breakdown of ‘UK ISA explained.’ Click here to read the full post. To get you up to speed first though, here are some quick ISA tips!
It stands for individual savings account. It’s a tax-free shelter for your savings and investments. This ensures that all the returns you receive can be paid to you without any tax deducted. You can pay a maximum of £20,000 per tax year into your ISA shelter. This can be done as regular contributions, a single contribution, or multiple ad hoc payments. You can generally access your money at any time.
Since ISA accounts were launched back in 1999, you’ve always been able to hold cash and stocks in them. The names Cash ISA and Stocks and Shares ISA just describe the assets that you hold inside the ISA shelter.
A Cash ISA is simply a savings account sitting inside an ISA shelter. The ISA ensures that you can receive all of your interest tax free.
Here’s the problem though:
Putting a savings account into an ISA like that is usually a total waste of your ISA allowance. The reason is that anyone earning up to £50k a year has a Personal Savings Allowance of £1,000. This means that their first £1,000 of interest every year can be received tax free anyway… Even outside of an ISA!
You could receive up to a further £5,000 tax free interest before that £1,000 too through what’s called your ‘Starter Rate For Savings Band’. If you earn between £12,500 and £17,500 a year (increasing to £12,570 and £17,570 from 6th April 2021), you receive the Starter Rate For Savings Band, but it reduces by £1 for each £1 that you earn between those amounts. For example, if you earned £15,000, your Starter Rate Band would be £2,500.
Higher rate taxpayers, (anyone earning between £50,000 and £150,000 a year), can receive their first £500 of interest tax free.
Interest Rates are at All Time Lows
As we all know with the current climate, interest rates on savings accounts are at pretty much all-time low. If you wanted to retain instant access to your money, the best you could find at the time of me writing this is 0.60%. If you’re willing to give up access to your money for 2 years, the best out there is 0.80%.
So, let’s say you were getting 0.8% and your first £1000 of interest could be received tax free… you could have up to £125,000 deposited outside of an ISA before you need to start paying any tax on your interest.
In other words, it’s not until you’ve got over £125,000 deposited, or £62,500 if you’re a higher rate taxpayer, that a Cash ISA would gain you any advantage at all.
Even if you had £250,000 deposited, or £125,000 as a higher rate taxpayer, the amount of tax you’d actually pay on your interest would only be £200 over the course of the whole year!
Therefore, placing cash into an ISA gains you no significant tax advantage. All it’s doing is removing the potential for you to invest into a stocks and shares ISA. This is where you can gain some real tax benefits.
Stocks and Shares ISA
A stocks and shares ISA allows you to invest into stock market instruments like direct shares, etfs, index funds and managed funds. You can invest into them either by seeing a financial adviser, or by going directly to companies like AJ Bell, Hargreaves Landsown, Fidelity, Vanguard or Moneybox.
They’re intended for longer term investment and the value of your capital will move up and down. The longer you are invested, the greater the certainty you have of getting a good return. Usually when you sell these types of investments, you have to pay what’s called Capital Gains Tax on the growth you’ve achieved. The power of the ISA is that it shelters you completely from this.
Because these investments provide much better growth potential, the tax saving benefits are much greater too.
If you had invested £10,000 a year into an index fund held 100% in shares over the last 10 years, and that fund had delivered an average return of 10% a year (which wouldn’t be unrealistic over that period), your investment would have grown to £175,000… a profit of £75,000.
If you sold those investments, that profit outside of the ISA would be subject to Capital Gains Tax. There is an exemption on the first £12,300 of gain on which you don’t pay any tax. The remainder is subject to either 10% or 20% tax depending on your own personal tax rate.
Let’s assume you pay the higher rate though. In this example, 20% on £62,700 would mean £12,540 tax is due, assuming there were no reinvested dividends, no loss relief or other exemptions.
If that investment was held in an ISA though, that tax would be ZERO. The power of the ISA therefore is only beneficial if you’re using it to shelter investments which have the potential to produce high growth.
So Don’t Make This Mistake…
Don’t waste your ISA allowance on a Cash ISA! Use your tax-free ISA wrapper to hold stock market-based investments. Utilise your Personal Savings Allowance instead and your Starter Rate Savings Band if it’s available to you, for cash savings.
This is also where inter-spousal planning can come into play. Ensuring assets are held in the right spouse’s name for the greatest tax advantage.
I’d love to know what type of ISA you’ve got at the moment? Are you saving into a Cash ISA and will you continue to do that, or will you consider a Stocks and Shares ISA? Let me know in the comments or over on my YouTube.
I’ll be back next week with more tax-free investing tips, until then, stay savvy and we’ll chat soon, Chris.