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Grab as much of your Individual Savings Account (Isa) allowance while you can, but think carefully about what you hold inside the wrapper. That’s the message from the experts as time runs out to use the £20,000 Isa allowance for the tax year ending on April 5.
The biggest tax increases in decades on capital gains will start the next day, combined with additional pain for dividend investors, making tax planning more important than ever. Sheltering assets that produce gains or income inside an Isa, where they can grow free of these taxes, has suddenly become urgent.
“Any interest, dividends and capital gains are tax-free in an Isa, making them a great tool for the savvy investor,” says Charlotte Tattersall, financial planner at wealth manager RBC Brewin Dolphin. “Investment Isas are going to become even more important, as other tax allowances are being squeezed from next tax year onwards. So, acting now, and utilising these Isa allowances is paramount.”
Moreover, those sensible enough to use as much as possible of their Isa allowance for 2022-23 before it expires face new dilemmas about what to do with the money — in particular, deciding between cash and investment assets, such as stocks and funds.
A succession of UK interest rate rises mean cash can provide significant income for the first time in over a decade. But with inflation high, it is, in real terms, losing value faster than when rates (and inflation) were low.
And, while history tells us that those investing their money in shares for the long term stand the best chance of beating inflation, the fallout from war and pandemic have left markets in an uncertain mood.
FT Money examines what’s changed and explains your options.
The tax burden on savings rises
In April, the threshold above which you pay tax on capital gains will fall from £12,300 to £6,000 and then again to £3,000 in April 2024. The threshold for taxing dividend income will drop from £2,000 to £1,000 in April, and to £500 in April 2024.
These cuts, announced in chancellor Jeremy Hunt’s Autumn Statement, will bring millions more investors into the tax net. They make shielding your investments in a tax-efficient wrapper such as the Isa, which protects income and gains from these taxes, even more essential.
Sarah Coles, head of personal finance at Hargreaves Lansdown, says: “Isas are set to save us a massive £4.3bn in income tax and capital gains tax this tax year — up a fifth in a year. Given the endless tax rises coming this year, and the enormous pressure on our budgets, every penny we can save in tax makes a huge difference.”
Nor will the burden decline any time soon. According to a freedom of information (FOI) request submitted by Quilter, the wealth manager and financial adviser, HM Revenue & Customs forecasts 1.13mn more people will pay higher-rate tax by the 2027-28 tax year, on top of 6.1mn this year.
Threats to Isa allowance?
With the public finances under pressure, the UK government wants to raise more tax. Even the Isa has been the subject of speculation.
While the Isa allowance remains generous at £20,000 a year, there’s political pressure to cap the total amount saved in Isas. In January, the Resolution Foundation, an independent think-tank focused on improving living standards for those on low to middle incomes, recommended reducing the generosity of Isas. It said capping the total amount of Isas savings that are tax-free at £100,000 would affect 1.5mn people and raise around £1bn per year by the end of 2023-24.
Meanwhile, there are rumours of plans for the state pension age to rise to 68 for those aged under 54. If this is announced in the March Budget, the minimum age at which this cohort can access private pensions is likely to rise to around 58 years old, 10 years before the state pension age. Isas are a good, tax-efficient way to plug any income gaps that this might create, because they can be accessed at any age.
Fiscal drag is the cause: the income level at which taxes start to be collected and the amount of income that can be earned tax free has not been increased at the same rate as inflation.
This can bring more of a person’s income into the tax net and lift more people into higher tax brackets.
Investment platform AJ Bell calculates that someone with an investment portfolio of £20,000 that yields 5 per cent a year will hit the lower tax-free allowance of £1,000 from April next year. Someone with a portfolio of £10,000 that yields 5 per cent a year will hit the tax-free allowance of £500 from 2024. So, it’s no surprise that tax planning was the number one financial priority for one in eight investors going into 2023, according to research by Interactive Investor.
Further evidence that investors are worried about tax comes in the form of high numbers of Bed and Isa transfers. These involve transferring assets held outside a tax wrapper into an Isa and are often useful to take advantage of any unused Isa allowance.
Interactive Investor, another investment platform, has seen a significant jump in online Bed & Isa applications since November 2022: in January and February 2023 they were more than double those in the same months last year.
Where to invest in uncertain times
Meanwhile, those making decisions about what to hold inside their Isas also face new challenges.
Low interest rates during the pandemic increased the appeal of investing in shares, bonds and funds. The latest Isa figures from HMRC show by the end of tax year 2020-21 the market value of adult Isa holdings stood at £687bn. Stocks and shares Isa holdings accounted for 58 per cent of the market value of Isas, up from 49 per cent in 2019-20. Cash Isas accounted for 42 per cent of the market value, declining from 51 per cent the previous year.
Since then, the Bank of England has raised interest rates, with seven consecutive increases in the 2022-23 tax year alone, taking rates from 0.5 per cent in March 2022 to 4 per cent today.
Has this surge of interest rates changed the attraction of cash vs shares Isas? Anna Bowes, founder of Savings Champion, says: “For the first time in years, it feels as though there is a proper Isa season for cash savers. And the good news is that cash Isa rates have been far better at keeping up with standard savings accounts.”
You can make up to 3.01 per cent on an easy access cash Isa and 4.25 per cent on a one-year fixed rate cash Isa. These rates are still losing out to inflation at 10.1 per cent, but those who find low-risk income tempting may still have to move fast.
Coles at Hargreaves Lansdown says: “If you’re planning on fixing your Isa savings, you may be tempted to wait to see whether the Isa season produces better deals — especially if the Bank of England raises rates in March. However, a rate rise is largely priced in, and the high street banks have plenty of cash, so you would be relying on smaller and newer banks pushing for more cash as the tax year draws to a close.”
Kirsten Pettigrew, chartered financial planner at wealth manager Saunderson House, says: “A common misconception is that cash Isas are ‘pointless’. However, for those that require the immediate security of cash, but in the future have an appetite for investing, a cash Isa can be an optimal saving tool given that you can transfer funds to a stocks and shares Isa in the future.”
Be careful when transferring Isa funds, though. Andrew Goulter, wealth management consultant at Leicester-based Mattioli Woods, says: “Cash Isas can be transferred to stocks and shares Isas and vice versa. However, it is important to transfer funds from one Isa to another without withdrawing them, as if funds are withdrawn, they cannot necessarily be replaced without using up your Isa allowance.”
While cash Isas have seen gains, investors in stocks and shares Isas may be nursing losses over the past year. The average stocks and shares Isa fund lost 3.27 per cent between February 2022 and February 2023, according to Moneyfacts research in collaboration with Lipper IM.
Rachel Springall, finance expert at Moneyfacts, says: “This should not be much of a shock considering the significant volatility felt across the markets over the past year, but it does emphasise the importance of keeping track of investments and ongoing fund performance.”
Investment platforms say passive funds, which track the performance of a stock market index, usually for a lower fee than actively managed funds, remain popular with Isa investors.
Bonds are back
If your Isas are mainly in shares, you might want to consider diversification into bonds.
James McManus, chief investment officer at Nutmeg, the UK’s largest digital wealth manager says: “After a difficult 2022, we believe we’re entering a different world with fixed-income soon offering a level of attractiveness not seen for years.”
Helena Powell at Evelyn Partners says that after bonds suffered their worst falls in 40 years in 2022, many bond fund managers — for example those at Twenty Four Dynamic Bond — have been locking in yields of 5-6 per cent in high-quality, investment grade corporate bonds, without taking on additional risk to get more income.
Alena Kosava, head of investment research at AJ Bell, recommends keeping duration short to damp volatility. She recommends the Royal London Investment Grade Short Dated Credit, which yields 3.3 per cent and has a duration of 2.9 years, slightly above its index benchmark, at 2.8 years, The portfolio is well diversified, holding some 280 bonds.
You could use inflation-protected US Treasury bonds to protect the real value of capital against rising prices. Helena Powell, associate director of investment management at Evelyn Partners, says: “As we all know, nominal government bond yields have risen sharply across the world over the past year, due to rising inflation causing an upwards re-rating of interest rate expectations. As a result US TIPS now offer a positive real yield for the first time in about a decade, plus the inflation protection on top.”
She recommends investors can get exposure to US Treasury bonds through the CG Real Return Fund.
Some tracker fund investors say they are sticking to what has worked so far and keeping investment simple and low cost. But others are reassessing the benefits of active managers. Rob Dix, author of The Price Of Money, says: “Previously I’ve invested most of my Isa allowance into a simple global tracker fund, but for the first time I’m allocating to actively managed funds.”
The benefit of global trackers is supposedly diversification, but most are market-cap weighted, so have 60 per cent exposure to the US. If you invest in Vanguard’s popular FTSE All-World ETF, you end up with 10 per cent of your portfolio in just four stocks: Apple, Microsoft, Amazon and Alphabet.
Dix says: “It feels to me that rising interest rates have brought us to a turning point, and the megacap tech companies that have benefited the most from low rates will perform poorly over the coming years. So I’m shifting into investment trusts that are geared towards global value shares.”
Experts warn investors not to make panic decisions. Dzmitry Lipski, head of funds research at Interactive Investor, says: “Difficult as it may be, it’s very important in these challenging times not to panic . . . History tells us that market sell off triggered by wars have been relatively shortlived and good returns come to those who wait patiently.”
Others urge investors not to shun passive, just because conditions have changed. Brian Byrnes, head of personal finance at Moneybox, says: “Low-cost, globally diversified portfolios have certain inalienable characteristics that make them very difficult to outperform over the long term .. In the end, that is all we need in our Isas and pensions in order to hit our goals.”
Tips to protect your Isa portfolio
Investors feeling nervous about where markets are heading have options to add protection to their portfolios.
One is with gold. Dzmitry Lipski of Interactive Investor says: “In the past gold has performed well relative to equities and other risk assets during periods of extreme economic turbulence, market volatility and high inflation.” He recommends the iShares Physical Gold ETF.
Or, you could introduce an actively managed fund or investment trust that focuses on capital preservation. Alena Kosava, head of investment research at AJ Bell, recommends Personal Assets Trust, which aims to protect and increase (in that order) the value of investments. It holds gold, cash and US Treasuries alongside a 23 per cent exposure to equities.
The trust does particularly well, she says, “amid challenging market conditions and souring economic sentiment — conditions we’ve been experiencing throughout 2022 and not being out of the woods just yet — which the trust’s experienced manager Sebastian Lyon had been concerned about for a long time.”
Others say keeping your investments in the UK is a good defensive move.
Peter Sleep, senior investment manager at 7IM, says: “The investors I speak to do not seem to be worried about the recent FTSE highs. I think with good reason as the FTSE has been one of the worst performing major global markets and still looks very cheap. In 2000, the UK was 11 per cent of the MSCI World index. Today it is around 4 per cent. If the growth sell-off continues, I expect the UK to be a relatively safe place to invest.”
Sleep recommends the Man GLG UK Income fund, which invests in companies that have net cash on their balance sheets but are undervalued by the stock market, and the Schroder UK Prime fund, which aims to beat the FTSE.
Other experts predict the trend of value outperforming growth may persist. Value investing involves picking stocks that appear to be trading for less than their intrinsic or book value, while growth investors look for companies poised to expand. For exposure to value investment, Stuart Clark, portfolio manager at Quilter Investors, recommends the Redwheel Global Equity Income fund.
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