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ISAs – how much do the tax benefits really matter?

We crunch the numbers to show just how much tax an ISA could save.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

Tax isn’t always the biggest concern for investors, especially when they’re starting out. Investors are often more focused on picking the best investment or trying to time the market.

But not investing tax-efficiently could cost you thousands of pounds over the long term.

We explain the tax benefits of ISAs and tell the tale of two hypothetical investors – one invested in an ISA and the other didn’t.

This article is not personal advice. If you’re unsure of the suitability of an investment for your circumstances, please seek advice. Tax rules can change and the benefits of investing in ISAs depend on your circumstances.

The tax benefits of ISAs

You can put up to £20,000 this tax year into ISAs, where your money has the potential to grow free of UK income and capital gains tax.

If your investments grow, you won’t have to pay capital gains tax. And if you’re investing for income, you won’t pay UK income tax either. The table below highlights the tax benefits of investing in an ISA.

Scroll across to see the full chart.

Non taxpayer Basic rate tax payer Higher rate tax payer Additional rate tax payer Investments held in an ISA
Tax on gains* (in excess of £12,000 annual allowance 2019/20) 10% 10% 20% 20% 0%
Tax on dividend income (in excess of £2,000 annual allowance 2019/20) 0% 7.5% 32.5% 38.1% 0%

*Excluding residential property.

The rates of tax paid by a Scottish taxpayer on dividend income and capital gains depend on the ‘rest of UK’ tax bands.

Why 2.8 million people saved into a Stocks and Shares ISA in the 2017/18 tax year

A tale of two investors

Our research team looked at two hypothetical long-term investors. Let’s call them Sensible Sally and Reckless Ron.

Both Sally and Ron invested the full ISA allowance each year, into the FTSE All Share (the UK market) since ISAs were introduced in 1999. Their contributions totalled £226,560 each.

But Sally invested inside an ISA whereas Ron chose to invest his money outside of one.

As at the middle of March 2020, their portfolios had grown to £311,892 and they are now higher rate tax payers. In the first scenario, they both take all their money out in one go and in the second scenario, they decide to start taking an income from their portfolio.

So, how much tax do they have to pay now?

Well, firstly bear in mind that this won’t be the first time Ron has encountered the tax man. Some of the portfolio he’s built up has come from reinvesting dividends – a great way to help boost your pot, but dividends mean a potential tax bill. For the sake of simplicity we’ve ignored it in this example but in reality Ron’s portfolio would likely be worth less due to the impact of tax .

Remember, the example below is based on a higher rate tax payer and assumes any income generated by investments wasn’t reinvested. A basic rate tax payer would pay less tax and an additional rate tax payer would pay more tax than the example.

All investments can fall as well as rise in value so you could get back less than you invest.

Scenario 1 – taking a lump sum

In the first scenario, both Ron and Sally have made a gain of £85,332 on their investments. But Ron paid £17,066 in capital gains tax (see table below) while Sally paid no tax.

Scroll across to see the full chart.

Value of portfolio (March 2020) Gain Rate of tax on gain Tax due on gain
Sensible Sally £311,892 £85,332 0% £0
Reckless Ron £311,892 £85,332 20% (on excess above £12,000 allowance £17,066

Remember, these examples are illustrations and past performance is not a guide to future returns. We have assumed both Ron and Sally have used their full CGT allowance already.

Scenario 2 – drawing income

If both Sally and Ron now decide to take an income from their portfolios, their tax burden would also be different.

Based on the yield of 4.70% on the FTSE All Share (as at February 2020), the income generated on the £311,892 portfolio would be £14,659 annually. Income will vary though and this isn’t a reliable guide to future income.

Because Sally has invested in ISAs, she doesn’t have any UK income tax to pay on her investment income. But Ron isn’t so fortunate. As a higher rate tax payer, he has to pay tax at 32.5% because he has already used his £2,000 dividend allowance.

This results in £4,764 extra income tax for Ron to pay via his tax return.

And that’s just the tax for one year. Depending on future taxes, he would continue to pay tax on the income his investments generate.

Discover more about ISAs

Tax year ends soon – Open or top up an ISA in minutes

As Sally and Ron’s example shows, it often makes sense to keep investments in ISAs over the long term. And with the end of tax year fast approaching – 5 April – time is running out to open or top up an ISA this year. But don’t worry, it’s quick and easy to get started.

Once you’ve decided to open or top up your ISA, you can usually do this in minutes online. All you need is your debit card and national insurance number to hand.

Before you apply, please make sure you're happy with our terms and conditions (including Tariff of Charges) and key features.

Find out more about our Stocks and Shares ISA

Open or top up an ISA

What did you think of this article?

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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