Saturday, 6 October 2012

# ..... ISA ISA baby.....#

In praise of the ISA.....(that's the 'Individual Savings Account' in the UK, which allows you shield capital growth and distributions from capital gains and income tax respectively).
I've been fully ISA'd-up for the last two years (£10,200 limit in 2010-2011, and £10,680 in 2011-2012), and I've also retained holdings in an earlier ISA from contributions I made around four and five years ago. 

I haven't yet added to my ISA pot in the current tax year, but I definitely expect to again be invested to the current annual limit (£11,280) before 5 April 2013, and also every subsequent year in the future assuming I can find the funds. 

I also recently closed my regular trading account with TD Direct and so the ISA account and my SIPP are the only trading vehicles I currently possess.

Considering that I run my own company, and have very limited personal pension provisions, I stumbled upon the benefits of ISAs very late in life – too late, many might say.

I run the ISA as part of my overall 'retirement' plan, not that I ever plan to retire, but who knows what tomorrow brings, as the song goes.  One of their best points for me is that I now don't have to declare any dividends on my tax return, thus reducing a record-keeping and administrative burden. 

Other major benefits of ISAs as part of your retirement funding are :-

  • unlimited and unrestricted access to your funds at any time prior to retirement, if you should need them earlier

  • the ability to pass the entire sum down to your heirs as part of your estate

  • you're not enriching some huge faceless third-party corporation who is one of only a very small and select group of fat-cats that's allowed to actually sell you annuities against your pension pot

As I said, I also have a SIPP, but I only make a nominal contribution each month, and the vast majority of my SIPP funding came from transferring several minor pension pots accumulated when I held various staff jobs many moons ago.  Some of these pots had been invested for almost twenty years but hadn't even managed to double the original investment sum in that time, and so when inflation is taking into account they were worth less in real terms than at the outset.

I also have 13 years' worth of contribution into a defined-benefits scheme from the company I was apprenticed to at the very start of my working life, and I'm not touching that at all.  That particular scheme is still going strong and is almost fully funded, and although my contributions were not too significant they should still give me a couple of grand per year when I'm 66 or so to add to my state pension and my own resources.

Personal pension plans are widely promoted as having significant tax benefits, but what's not generally advertised is that you obtain tax relief on your contributions, but you must pay tax on the pension when you draw down the investment later in life.  So the government currently gives you 20% to add to your pot, but then takes 20% of a (hopefully) much larger pot later in life, so in the long run the government stands to gain more than it loses.

Some might argue that you get tax relief at your highest marginal rate when you're working, and that you might only pay the basic rate on your pension when you retire, but that doesn't work for me.  I'm always a basic rate taxpayer – I only ever take enough as salary and dividends to keep me just below the higher rate threshold, and let the rest accumulate within the company – I don't need more than £40k gross or so per year to live on, so why draw more and suffer punitive taxation on it ? 

As part of my 'retirement' planning, by this strategy I can hopefully continue to draw a salary from the company's funds for as long as they last, whether I'm actually doing any useful work or not.

The UK annual personal allowances and marginal rates mean you pay at lot less tax taking say £40k each year compared with taking £80k one year and nothing at all the next.  These days, the annual personal allowances are being significantly increased every year by the present government and, if it continues, I may be able to get by in the future by just drawing down funds from the company up to the limit of the annual allowance and then I'll pay no personal income tax or national insurance at all on a salary.  However, of course, the company must still pay corporation tax on its annual profits, and if I'm drawing a lower salary then it results in reduced allowable operating expenses for the company which in turn increases the profits subject to corporation tax – the company has no similar free-of-tax allowance before taxation and so it's a fine balancing act.

Within an ISA, there's no tax relief at all on your contributions, but beyond the statutory tax deduction on any dividends received (which is not recoverable either within an ISA or a pension plan), there's no further tax to pay on distributions or capital gains regardless of your tax status or marginal rate.

Regarding the particular stock holdings in my ISA and SIPP, that's for a future post...


  1. Great article, especially like the title :)

    I love the ISA as well, who doesn't right?! Although for years I never understood you could invest in the stock market in one. Silly me.

    One quick question on this bit:

    "Beyond the statutory tax deduction on any dividends received (which is not recoverable either within an ISA or a pension plan)"

    I've read about this before but don't really understand the mechanism. Is this done automatically before dividend payments are even paid back into your ISA (or other) investment account? I presume it works like that or there would be a lot more paper work at the end of each year on everyone's tax forms?


    1. Hi. Thanks for stopping by again. On the dividend front, it's a little complicated...

      Dividends are paid over in full as declared, but in reality they're 'net' of what's called a 'tax credit' which is equal to 10% of the 'gross' sum actually paid over to you. For example, if my company (or any other) pays me a £1,000 dividend, the gross I have to declare on my tax return is £1,000 / 0.9 = £1,111.11, i.e. the tax credit is £111.11.

      If I'm a basic rate (20%) taxpayer, then there's no further tax liability - this is because before declaring the dividend, the company has already paid over corporation tax on its profits (companies can ONLY pay dividends out of profits, i.e. either from the current year or those 'retained' and accumulated from previous years - this is how some PLCs can maintain their dividends even in the bad years because they typically don't return 100% of each year's net profits to their shareholders. The difference between the total earnings and the dividend actually distributed is call the 'dividend cover' ).

      However, a higher rate tax payer (<£150k income) has a liability to pay a total of 32.5% on all dividends and so needs to pay over an additional 22.5% when he submits his tax return, i.e. £225 in my example. If you earn more than £150k pa then it's an additional 27.5% or £275.

      This link explains it better than I can :-

      Go back to the pre-Gordon Brown days, and recognised pension companies could reclaim this tax credit on your behalf and so the net effect is that the dividends in your pension account would be 10% higher. Now they can't do this -, it's what's commonly called Gordon Brown's 'raid on pensions'...

    2. This comment has been removed by the author.

    3. I forgot to add, of course, in either an ISA or a SIPP there's no additional tax liability to pay whatever your earnings, whereas in a standard taxable share account you need to pay the additional sum to HMRC each January....