158- ISA Misconceptions

Benjamin continues the misconception series in this episode by addressing the humble ISA. 

How many of these were you aware of? 

Here's the link Benjamin mentioned in the episode: pensions or ISAs - which is better? 

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Transcript

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SPEAKER_01 0:11

Hello money nerds, it's Benjamin Mitchell here. Thank you as always for joining me on Heads Up on Money. It is Personal Finance Friday, and this is episode 158. We're continuing my little mini-series on financial planning misconceptions. If you haven't already, then listen back to last week's episode 157, where I debunked some of the common myths surrounding pensions. A couple of people have actually reached out to me to say that was an interesting episode by personal finance standards. Interesting, I say. But I'm glad it's landed well. So if you haven't already, do listen back to last week's because today's episode builds on very nicely from that. Today we're talking about the humble ISA. So a pension and an ISA are two of the fundamental building blocks that should underpin almost every financial plan. Now, of course, your situation, your objectives may be different, but generally speaking, there's rarely a financial plan I see where the underlying financial plumbing within it will more often than not, at the basic level, include an ISA and a pension. Now, arguably the ISA is one of the most common things that most people know about in personal finance. Most people have an ISA of some sorts. Sadly, too many people are holding cash ISAs rather than investment ISAs, and I think that's because we are just not educated about the underlying principles of investment risk, investment volatility, and we think cash is best. I'm not going to go into that too much in this week's episode, but the ISA is full of misconceptions. So many of us don't understand the full intricacies of the ISA wrapper. Now the ISA actually is beautifully, it's beautifully simplistic. However, again, not getting too much onto my soapbox, there are changes that are coming in with ISAs, particularly around the age of 65, where the ISA allowance is not going to be as simplistic as it once was. Generally speaking, if you want a deeper dive on that, I've done an episode 146 on what's changing with ISAs. The long and short of it very much is that if you are under 65, you are not going to have the ISA allowance that you normally had with regards to how that applies to cash ISAs. So, generally speaking, you had a 20 grand ISA allowance and you could allocate that as you wish, depending upon the flavour of the ISA that you desire, be it cash or investments. The government, in a bid to try and stimulate more of us to start investing for our futures rather than saving, have effectively or are bringing in some rules. If you're under 65, then effectively the maximum amount you can invest in cash is £12,000. So it's almost saying if you want to use your full £20,000 ISA allowance, you have to use 8 grand of it towards investments. So that is some changes coming in with ISAs, which I'm not entirely a fan of, to be honest. Listen back to the episode I talked about if you want a deeper dive on this, but my view very much is is this going to stimulate people to invest? I don't know. And the beauty of the ISA was its simplicity. There's lots of complexity around personal finance that doesn't need to be there, and these ISA changes that are coming in arguably do not need to be there either. So parking that for one minute. Let's get into this episode. ISA misconceptions. What do you actually need to know? So ISA, individual savings account. Most people, as I said, have heard of an ISA. You've probably got one yourself. You might have a few cash ISAs sitting around, maybe you've got stocks and shares ISA, or maybe you've just heard people talking about their ISA allowance and thought, you know what, I really should do that. I should be saving tax. But despite ISAs being around for years, as I said, there's a lot of misconceptions about what they actually are, what people use them for, and most importantly how they fit in with your financial plan and your financial life goals. So today, hopefully in the next 20 minutes or so, I'm going to clear up some of those misconceptions. And as I did in last week's pension misconceptions episode, I'm just going to go through them one by one. Some of them may be relevant to you, some of them maybe you don't care one bit about, but hopefully there will be one or two nuggets in here. So point number one, misconception number one, an ISA is an investment. It's a simple misconception, but the ISA is not actually the investment. I've talked about this before in the podcast. The ISA, in the same way that a pension, is actually just the wrapper that goes around the investment. And that investment can be in stocks and shares, it can be in bonds, it can be in cash. The flavor of the underlying asset class within the ISA will determine the growth trajectory, whether you are going to offset inflation over the longer term or not. The ISA in itself is just the tax wrapper, it's just the box around your asset that basically has certain tax privileges. So imagine you've got two boxes around, let's say, a globally diversified equity portfolio. There's a pension box around one of them and an ISA box around the other. The only way they differ is in the nuances and subtleties of the tax treatment or how the wrapper is dealt with on death, or you know, lots of lots of minutiae, but the point is it's the actual rapper itself that is the ISA, or the rapper itself that is the pension. So people often say to me, my ISA is absolutely crap. I'm getting a terrible return on my ISA. And that's often not the case. The reality is you're getting a terrible return because of the asset classes you hold within your ISA. So that is often more important, is what is in the ISA. It's not the ISA itself that is the investment. And what I mean by that is two people could say they've got an ISA. One might have cash earning interest as their return, the other may be in a stocks and shares ISA, an investment ISA, whatever you want to call it, they'll be invested in global equities. The first person is going to have no volatility, they're going to have a comfortable ride, it's going to feel safe, it's going to feel like they're doing enough. The reality is inflation, terminator of wealth, is going to ravage their wealth and compromise their ability to meet their long-term objectives. Whereas the second individual, yeah, they're going to see some volatility. They need to understand that when there's a short-term sneeze in markets, that's going to have a direct impact on the value of their ISA. But if the ISA is for the medium to longer term, that shouldn't concern them. And investing in real asset classes like companies, which is all the equities are, should offset the terminator of wealth that is inflation over the long term and hopefully permit them the ability to meet their long-term goals. So they can both have an ISA, but the returns and growth trajectory and the investment journey will look very, very different. Misconception number one, an ISA is just an investment. It's not. Misconception number two. Cash ISAs always better because they're safer. I'm not going to go into this in detail. I've gone through it many a time in the podcast. Cash is not king. The terminator of wealth, it is inflation, absolutely demolishes the value of cash over the long term. The reality is saving is not the same as investing. Cash is saving. Investing is what you need to do for the long term. Yes, there's a role to have cash. No, you shouldn't be allocating all your wealth to the investments of the stock market and globally diversified equities. That would be ridiculous, also. But the reality is that investing is not high risk. Being overweight in cash is high risk. And this is why the government are bringing in lots of measures to try and encourage more of us to invest. Arguably, the damage has been done. We're a very risk-averse nation. T's and C's, health and safety, compliance. We are absolutely grounded down to assume that risk is a bad thing. It is not when it comes to your investment journey. Risk is a good thing. Risk is the cost you pay short term to achieve your long-term goals. So misconception number two, it's short and sweet, but cash ISAs are always better because they're safer. Cash is not safe. You need to look into the actual definition of what is meant by safe. If I was to say that investing in an asset class such as cash that is going to guarantee low uh lose its value over the long time frame, would you say that is a safe investment? I certainly would not. Misconception number three. The ICE allowance, I'm not going to get into the details here in this episode, but broadly speaking, 20 grand ICE allowance, yes, there are changes coming in with how that shapes up, as I talked about. But the misconception here I see quite often is if I do not use my ICE allowance, I can carry it forward. So it's an important one because ICE allowances do not work like pension annual allowances. Generally speaking, with pension annual allowances, you have a rule called carry forward, whereby you can potentially use unused contribution amounts, let's call it that, unused allowances from your pension from the preceding three tax years, which means you can potentially get a sizable contribution subject to certain rules, please do seek advice, into your pension in one tax year by using up unused allowances from the three preceding ones, but that doesn't apply with ISUS. It is very much use it or lose it, which is why I start to go grayer round about the February-March time of the year as I'm chasing a lot of my clients to see if we've used fully used their ISA allowances, and if not, can we get some money parts in ISAS before the end of the tax year? Because once the tax year is over, that ISA allowance is gone. And obviously, you get a new one when the clock resets, but it will impact how much you can pay into ISAS and how much you can shelter from ongoing tax immediately. So if you've got, let's say, the £20,000 ICE allowance for the year, you've contributed £5,000 at the start of the year, parts it in a cash ISA, it gets to the end of the year, you don't quite have enough, but you say, you know what, I'm going to come into some money next year. Potentially, I could put in £35,000 next year, being £20,000 in the next year, and the £15,000 you've not already used, well, that is not the case. You could only pay in £20,000. So it's really important. Object obviously, you need to have the money there in the first place, but just be mindful of this fact. You shouldn't put money into an ISA that you need for your immediate expenses simply because you're worried about wasting an allowance. But if you have money that you were already planning to save or already planning to invest, it's worth understanding this key point that the £20,000 limit does not carry forward into the next tax year. Misconception number four. You have to invest your entire ISA allowance. It's absolutely not the case. Your ICE allowance is an opportunity to shelter money from tax, it's a ceiling, not a target. So something is almost always better than nothing. So do not be disillusioned if you cannot use your full 20 grand ISA allowance. It can still be tax-wise planning to shelter as much of your wealth as you can within the ISA wrapper. Next misconception is that people tend to think ISAs versus pensions. Now that is not the case. I always try and encourage clients to think of them as complementary wrappers that can be very useful in your financial plan. A lot of people tend to think that ISAs are good, pensions are bad because pensions lock up your wealth for the long term. Pensions you pay tax on the way out, and ISA you don't. However, there is obviously pros to pensions when you pay into them because you get tax relief and free money going in. So generally speaking, the best financial plans involve both pensions and ISAs. And I talked about this recently in the podcast where I talked about the retirement danger zone whereby you potentially are too young for pension wealth to be accessible, you're too young for your state pension, you may need ISAs at that point, or you may be of a pensionable age, but you may dovetail in drawdown from your pension with ISA withdrawals because that would be more tax efficient than taking perhaps too much from your pensions, incurring higher rate tax relief or additional rate tax relief, and that would not be tax-sensible planning. So having both of them is really good planning for the long term. I've got an article on my website, headsupwealth.co.uk, if you want to have a little read on why it's beneficial to have both a pension and an ISA. I'll include that in the show notes. But misconception, I hear all the time: should I have an ISA or should I have a pension? It is not, or it is very much, and the best financial plans involve them both. Misconception about tax and ISA. So some people say, you know what, I don't pay much in tax, so I don't need an ISA. Now that can be accurate for some people, particularly if they're just holding a cash ISA and it's a small amount they'd be putting in the ISA and they don't pay much in the way of tax, yes, the ISA wrapper can be redundant. And what I mean by that is that the actual purpose of using an ISA is to shelter your investment returns from income tax and capital gains tax. Let's keep it simple. And once you've got money in an ISA, if there's ongoing income tax liabilities and an eventual capital gains tax liability when you sell, you don't pay those taxes, which is great. Now, out with the ISA, you do have some tax freebies at your disposal. That means you do not pay capital gain tax or income tax automatically because of things like your starting rate banned for savings, your personal savings allowance, your personal allowance, you've got a capital gains tax exemption. I'm not going to go into the weeds in this episode. But for some people, regardless of whether you hold it in or out with an ISA wrapper, you may not have a tax liability in the first place, which does mean possibly ISA isn't needed. And when I get up in my soapbox around this, is I'm, you know, of no surprise, probably to you, money nerds, not that big a fan of cash ISAs. And the reason is, of course, the interest you accrue within a cash ISA isn't really optimizing the ISA tax environment. You're not making the use of the beautiful tax privileges within the ISA because you're not likely to pay much unless you've got a sizable amount in a cash ISA, accruing significant amounts of interest and hence income tax, it's unlikely you're going to be incurring much in the way of taxes anyway. Surely to get the most from the beautiful ISA environment, you want to have an asset class in there that's going to attract fairly sizable levels of income tax liabilities and fairly sizable levels of capital growth. In other words, you want to have stocks and shares and investments in your ISA, not cash. Stocks and shares and investments within an ISA really ramp up the benefit of the ISA wrapper because if you have sizable levels of income tax, and a reminder, this would be things like dividends accruing within your investment portfolio. Regardless of whether those dividends get paid out to you or whether they just accrue within your investment fund and they buy more units and it rolls up and does all the great things I talk about all the time when heads up on money, there's still technically an income tax liability growing there, but that income tax liability is wiped out because you're in an ISA. And then you make a withdrawal in the future for perhaps retirement planning for the danger zone I talked about. You make a sizable withdrawal or a withdrawal every tax year out of your ISA. There's no capital gains tax liability on that. Even though you've had masses of capital growth over your investment lifetime, that's when an ISA is at its most beneficial. Conscious time is moving on. Let's talk about the cheery subject of ISAs and death. So for many people, they assume when I die, that means my ISA, all those tax privilege savings I've accumulated over my lifetime is going to absolutely evaporate. And that is the case mostly. However, there's something called the additional permitted subscription, the APS, which essentially means your ISAs pass over to your spouse when you die, and they retain the ISA tax-privileged environment. Now I think many people don't know about this. So let's say you're married or you're in a civil partnership and your partner they've built up £475,000 in an ISA, and in that ISA, when they're alive, they pay no income tax and they pay no capital gains tax. So when they pass away, there may or may not be inheritance tax issues on the ISA. That will be determined by your wider estate and all of the complex inheritance tax stuff that goes on in the background, but let's park that for now. So what happens in this case to the ISA when your spouse dies? So common misconception, people assume, well, an ISA is personal to an individual. I mean it's in the name, individual savings account. When they die, it just becomes part of their estate, the tax benefits disappear, and then it perhaps gets paid to your bank account. That's not quite how it works because there's something called, as I said, an additional permitted subscription, and it's potentially a very valuable part of ISA planning for married couples. So in this case, the amount that had been built up in an ISA would effectively go over to you and you would receive an additional ISA subscription on top of your normal annual ISA allowance for that year. So for instance, you would have £475,000 as your additional permitted subscription plus your standard £20,000 in that tax year, which means there's an almost like a freebie of how much you can retain in an ISA in that year of the death. So it's incredibly, incredibly important. A lot of people don't recognize this, and a lot of people are put off from ISA saving because they think, you know, what's the point? Because it's all going to wash out on death anyway. And that's not necessarily the case. So the APS allowance is available to the surviving spouse. But here's another critical misconception is that it's not necessarily the deceased's ISA assets that are inherited, but rather it just gives you another ISA allowance for that year. So this additional allowance, the APS, as I said, is an addition to your normal ISA allowance, but it doesn't mean you necessarily have to inherit the spouse's ISA. You could take those ISA assets and wash them out as you wish, but then you may have other things going on in your financial plan that means you could make a sizable ISA permission declaration in that year, and you effectively have a massive spike in how much you can pay into an ISA in that tax year. However, you may have your own financial plan, your own investment provider, your own ISA provider that you wish to make that subscription with. So there's nothing to say that you necessarily have to inherit the existing ISA in the flavor that it was in, whether that's cash or investments, and whether it was with XYZ platform, you can make of it as you will. Effectively, you just inherit the value of it, and that's how much you can put into an ISA in that year, and you don't necessarily have to keep it as it was, if that makes sense. So there's a bit of misconceptions around that, but generally speaking, to keep this high level is when someone passes away, their ISA doesn't necessarily evaporate if you're married or in a civil partnership. Okay, I'm gonna try and wrap that up there because this could be a lengthy one, and I'm trying to keep the humble ISA fairly simple, despite the government's best intentions. So hopefully, this has been beneficial in some ways to help address some of the confusion you may have around ISAs and where they may fit into your financial plan. The key takeaways I really want you to take Money Nerds is just a reminder that the ISA is just the tax wrapper that accompanies your asset class. It's the asset class within it that will determine your return trajectory. ISAs can be beneficial, but most beneficial to people if they are paying higher levels of tax and you are using the ISA in the flavor of an investment ISA, a cash ISA is not likely to be optimizing the benefits of the ISA wrapper in most cases. So investment ISAs, they're great. They shelter tax, the shelter capital gains tax and income tax, it rolls up very beneficial over your lifetime. It can be massively helpful later in life, dovetailing in with a retirement plan and your pension. Listen back to my episode in the retirement danger zone. That's where ISAs come into their own. It's not pension or ISA, it's pension and ISA. And if you pass away and you're married or in a civil partnership, your ISA can go to your spouse in a tax-efficient way, so it doesn't necessarily disappear on death. There we go. I hope that was helpful. Do let me know by reaching out to me. I love to hear your comments. And if you've enjoyed this episode, as with any other episode of Heads Up on Money, and you haven't done so already, please do like, please do subscribe, and please leave me a comment if you're listening on Apple Podcasts, as it really helps the podcast reach more people. I've been Benjamin Mitchell, you've been the Money Nerds. We'll continue the Misconception series next personal finance Friday. But in the meantime, stay safe out there, have a wonderful week. Thank you for joining me as always every week, week in, week out, episode 158. This has been ISA Misconceptions. See you next week.