| Real Life Strategies for Building Wealth

From this comprehensive guide to ISA you will learn:

  •    What kinds of ISAs and you can choose from?

  •    What are the benefits (and faults) they offer you while building wealth?

  •    Why ISA is a high priority investment? and

  •    What are the little known rules of ISA?

I’m chilling, soaking the sun at the swimming pool.

‘My ISA is at 0.75% interest per year.’

What? This can’t be right; no one, I mean no one, keeps his tax-free savings in an ISA account yielding less than 1% per year. This is so much below the running inflation rate (2.74% now) that this guy’s savings are leaking like an old bucket.

I open my eyes and look around. Yes, it is true. Colin, our neighbour at the holiday hotel, has just told an acquaintance that his ISA yields 0.75% interest per year. I approach and start acting as an impromptu guide to ISA.

‘You have to move your ISA, Colin.’ – I hear myself saying. ‘This is well below the rate of inflation and you are losing money. Look at opening a stocks and shares ISA with one of the digital wealth managers. Check out Nutmeg and Scalable Capital. Have a look at Vanguard – they offer ISAs and you can select your index funds. Or, if you are prepared to lock your money in for some time, you could look at an Innovative Finance ISA; check out The House Crowd for this one.’

Okay, my mum raised me well and taught me not to interrupt people’s conversations. My acquired British(ness) is screaming at me not to talk money at the swimming pool. And, let’s face it, I wasn’t too keen on talking about investing and money in my bikini, over-heated by the sun and ready for my restorative swim.

This is not why Colin’s eyes glaze over. It is not why I feel the confusion in the people around us. And as we all know when it comes to money and investing, confusion is not good.

Colin’s eyes glaze over because he doesn’t know enough about ISA to make sense of my blurted out and, I like to think, helpful suggestions.

This is why I decided to put together this comprehensive guide to ISA. Here you will learn:

  • What kinds of ISAs are on offer (and you can choose from);
  • What are their advantageous characteristics and faults;
  • Why ISA is a high priority investment; and
  • What are the little known rules of ISA.

What is ISA?

ISA is an individual savings account where you can save £20,000 per year (this is the current amount which may change in the future).

Simply put, an ISA is a beautiful wrapping paper which can cover all kinds of (tax free) sweets.

Kinds of ISA you can choose from

ISA started as a simple financial instrument to encourage people to save and invest for their future. Or this was the intention.

Since its elegant beginning, ISA has developed. While we are not sure whether the instrument has matured or not, we can safely say that it is by far not as simple as intended.

Remember I told you that you can think of ISA as a beautiful rapping paper around many, and tax free, chocolates? For instance, you can have:

  • Cash ISA that hides bland white chocolate.
  • Investment ISA that covers rich dark chocolate holding so much promise (but could be a bit bitter).
  • Lifetime or Help to Buy ISA that hide milk chocolate with some attractive government inducements.
  • Innovative Finance ISA which when un-wrapped is like a smooth chocolate with delicious hazelnuts.

Having said that ISA is the tax-free wrapping paper around a whole array of possibilities, each ISA type has specific features that are worth keeping in mind.

Cash ISA

Cash ISAs are very similar to normal savings accounts with one difference: you generally don’t need to pay tax on the interest that it earns. To open a cash ISA you have to be a UK resident aged 16 and over.

There is strict annual allowance that you can save in the cash ISA, which is £20,000.

There are different kinds of cash ISAs. These are:

  • Easy access. These ISA accounts are easy to access and pay variable rates of interest.
  • Fixed rate. These ISAs pay a fixed interest rate for a set term. Put differently, these account offer higher interest rates than the easy access, variable accounts but you have to be prepared to lock in your money for a certain period.

Stocks and Shares ISA

There is a wide range of stocks and shares ISAs and even their name is misleading: you can invest in anything within an ISA including ETFs, bonds etc.

Apart from that, you can go for a simple arrangement, like the one offered by Nutmeg or Scalable Capital, whereby you simply specify the level of risk you are prepared to take and leave the constitution of your portfolio in the hands of experts.

If you like to be a bit more hand on, you can go with a platform like rPlan. And if you really like to play around with stocks and shares you can use many Internet based stocks trading platform.

It is important to remember though that putting your money in stocks and shares ISA carries the inevitable risks of investing.

Junior ISA

Junior ISA is a tax efficient way to save for the future of your children.

To open a Junior ISA on behalf of a child you have to be over 16 years old and UK resident; or be over 16 and less than 18 years old to open one for yourself.

There is also the small matter that a child is not eligible for a Junior ISA if they qualify for child trust fund (CTF). This effectively excludes children born between September 1, 2002 and January 3, 2011.

Lifetime ISA

The Lifetime ISA (LISA) is available since April 2017.

It aims to encourage people to save more for buying their first property or retirement.

You have to be between 18 and 40 years old to open a LISA and the annual contribution allowance is £4,000. Good news is that the Government will match any savings in a LISA with a 25% contribution.

Sounds interesting but let’s see how it is going to work.

Help to Buy ISA

This ISA was launched in December 2015 and is open to first time house buyers only.  According to the rules, you can save £1,200 in the first month of opening the ISA and £200 per month after that. When using this to buy a house the Government contributes a bonus of 25% of what you’ve saved (min. £400 and max. £3,000).

What is interesting with this one is that the account is available to each house buyer, not household. This means that if you and your partner were to open Help to Buy ISAs, you may receive a bonus of up to £6,000.

Not a fortune but nothing to be sniffed at, I say.

Innovative Finance ISA (IFISA)

Innovative Finance ISA allows you to use some, or all, of your ISA investment allowance to lend money through peer-to-peer landing platforms (companies) and receive tax free interest and capital gains.

This is a relatively recent provision introduced in April, 2016. One implication is that it is hard to report historical results of Innovative Finance ISAs offered by different providers.

There is considerable interest in this ISA, both on the side of industry and on the side of individual investors. Innovative ISAs are currently being offered by established (and Financial Conduct Authority approved) peer-to-peer lenders. You may wish to check CapitalRise.com who boast 10% annual returns or The House Crowd who promise a more modest 7% per year.

What is worth watching for with this ISA is that providers generally ask you to lock your money in for a period of time (between one and three years) and some are not protected by the FSCS.

Why ISAs are a good investment?

Here is why I believe that investing in stocks and shares ISA is the best thing that you can do for your money.

#1. Stocks and shares ISA is very tax efficient

Tax evasion is morally bankrupt behaviour (call me old fashioned, if you wish but this is what I believe). Making sure that your money affairs are conducted in most tax efficient manner is smart move.

This is where, investing in a stock and shares ISA (or any ISA for that matter) is hard to beat. (You can check out this comparison between a stocks and shares ISA and a SIPP account, if interested. If you are short on time, I can tell you that in the long run the ISA wins.)

ISAs are tax efficient in two ways:

#1. When you keep within the tax-free ISA limit, which for 2017-2018 is £20,000, any investment returns, and dividends, are not taxed.

#2. There is no tax when you withdraw money from your ISA.

Yes, I know that you contribute after tax income in the ISA but still – as investments go, a stocks and shares ISA is ultimately very tax efficient.

#2. Stocks and shares ISA is flexible

Stocks and shares ISA is very flexible investment vehicle.

Your choices are many.

  • One choice you’ll have to make is about what to include in your ISA –value and dividend stocks or ‘basket’ investments like ETFs and Index Funds.
  • Another choice is whether you’d like to tinker with the content of your stocks and shares ISA yourself or you’d rather delegate its management.
  • Do you prefer fully managed ISA or you’d rather have a fixed allocation one?
  • And you ought to select an investment platform for your ISA.

Apart from that, you can transfer your ISA were you to find a better provider or your requirements change over time.

One question that people ask me is whether they can split their ISA allowance between several providers.

Yes, you can. I have split my stocks and shares ISA between Nutmeg and Vanguard – make me feel better (diversification) and it is one of my little experiments.

What is important is that you don’t exceed the annual tax-free ISA allowance. All else is flexible and can accommodate even a fussy investor.

#3. Stocks and shares ISA is hard to ‘violate’

Do you ‘violate’ your savings accounts?

You know what I mean, don’t you? The situation where you have a bit of overdraft and pull some money out of your savings.

(I do this sometimes. Life doesn’t care much how good my money management skills are; it happens and when it throws me a money curve ball, I go to the money transfer button.)

You can’t do this with stocks and shares ISAs – or any ISAs for that matter. Okay, it is technically possible, but it is such obviously dumb move that most people think ten times before do it. You see, when you’ve withdrawn money you can’t replace it tax free.

#4. Stocks and shares ISA can be great for ‘beginner investors’

Many digital wealth managers offer, what I call ‘off the shelf’, stocks and shares ISAs. If you don’t have much experience investing and would like your money to do better than lose 2% per year in a savings account (or a cash ISA) you can look at ISA providers like Nutmeg, Scalable Capital and Vanguard.

How to choose the right ISA for you

Now that I hope to have convinced you that ISAs are a good investment, particularly stocks and shares ISAs, let me tell you the four things I believe you should consider selecting the one for you.

These are not something that I’ve plucked out of thin air. Quite the reverse; these are the four rules that according to Tony Roberts (in his book Unshakable) ensure that our investments are sound without being overly conservative.

Rule 1: Risk awareness or what is the potential loss?

Before you go and open a stocks and shares ISA (never mind the provider) you must be aware that it is extremely unlikely it will only make profits. There will be times when the value of your ISA (your investment) will go down.

You also need to be aware that I’m not talking about your ISA going a little bit down. Research shows that at least once per year there are dips of 10% or more. Scary stuff, uh?

Well, not really. Despite these steep drops most years the stock market recovers and finishes up (there are very few exceptions).

Apart from that, roughly every three-four years we experience what is known as ‘bear’ market. This is when the stock market drops by 40% or more. This is real scary…in the short run. Again, research shows that the market always recovers and over-recovers; but it may take couple of years or so.

Your ISA doesn’t have to behave so erratically but this will depend some of the things we’ll discuss later. What is important is that you know that dips are normal so that you can ‘sit them out’. The worse thing for you and your ISA would be to pull out of it during a dip.

Rule 2: Profit awareness or what is the potential return?

Profit awareness when selecting an ISA is important but not that easy to judge. One thing you could do – when opening an “off the shelf” stocks and shares ISA – is to look at the returns that the provider has achieved historically.

Not perfect but still something.

Rule 3: Tax/fee awareness or what tax and charges you have to pay?

Taxes and fees can obliterate your earned interest; when compounded it gets scary.

When you select the ISA for you, please make sure that you understand all fees and taxes you’d incur. Remember when I told you that one of the best things about ISAs, is that they are tax-free?

True. You still need to watch these fees. Some managed ISAs can have rather steep fees and even digital wealth managers divide their fees in several categories.

Remember: the lower the fee, the more likely it is that your ISA is a good investment.

Rule 4: Diversity awareness or how diversified is your ISA?

Any investor, even a beginner, knows that diversification reduces risk (there are caveats, but we won’t get into these now).

When selecting an ISA, you should make sure that it is diversified across:

  • Financial instruments: your ISA is a portfolio that can contain equities, bonds, real estate funds, commodities and cash. Usually the proportions would depend on your risk tolerance and the type of market.
  • Industrial sectors. Having a stocks and shares portfolio of companies from one sector is risky.
  • Location. Experience shows that the stock market rarely collapses globally at the same time. This means that if you own only UK companies (or US companies) you are exposed to rather severe drops in value. Owning shares in companies in different countries can lower the drop substantially.

The ideal stocks and shares ISA formula:

Ideal ISA = (Relatively) low risk + high (potential) returns + low fees + high diversity

Little known rules of ISA

I have been investing in ISA for close to a decade now. I’m usually careful to learn the rules – it comes handy when I want to break them intelligently. You’d think that I’m well versed with the rules of ISA, right?

I also thought I know the rules well. Until, last year we nearly gaffed big time because I somehow had missed the rule that you cannot invest in two ISAs of the same type in the same tax year. Go figure!

I nearly gaffed; you don’t have to. I researched the less known rules of ISAs. Here they are. I’ve presented these rules as seven questions.

Rule 1: Can I sell my stocks and shares ISA?

Yes, but…

You ought to remember that a stocks and shares ISA is like the rapper of a lovely piece of chocolate. You can rap any kind of chocolate in it – index funds, ETFs, individual stocks and combination of all these.

You can always sell the chocolate.

An important question to ask yourself is not about the rules of stocks and shares ISA but about intention. In other words, don’t ask whether you could sell your ISA but whether you should sell it.

Most people, sell their stocks and shares ISA when they:

  1. need the money;
  2. try to minimise their loss when the value of the ISA has declined.

You can’t do much if you need the money though dipping into your stocks and shares ISA is not ideal.

Selling because you fear loss, however, should be avoided at all costs. Remember that statistically downward stock market corrections recover in three to twelve months.

In brief: Yes, you could sell your stocks and shares ISA but you probably shouldn’t.

Rule 2: What happens to my stocks and shares ISA when I die?

Good question though I hope it won’t come to that anytime soon.

According to the old rules of stocks and shares ISA, were you to die your ISA would have lost its tax-free status. This means that your partner (or any beneficiary from your estate) would have had to start paying tax on any returns or income earned from it.

This may not sound very bad if we are talking about small amounts of money but could add up to a lot if you (your partner) have been saving and investing according to The Money Principle ideology.

This rule changed in April 2015.

According to the amended rules of stocks and shares ISA, the tax-free benefits can be passed on by increasing the beneficiary’s tax free allowance for the year of death to include the value of the inherited ISA.

For instance, if I die in 2018 John’s ISA allowance for 2018-2019 would be:

£20,000 + value of Maria’s ISA

In brief: Save and invest in a stocks and shares ISA with no concern – your loved ones would benefit greatly from it without losing the tax free advantages it offers.

Rule 3: Can I have more than one stocks and shares ISA?

This question has a short answer and a bit longer one. Who said that anything about ISAs is straight forward?

In brief, yes can have more than one stock and shares ISA.

But, you ought to understand two things, though:

  • You can open one stocks and shares ISA, with a different provider, per tax year.
  • During a tax year you can contribute to only one stocks and shares ISA.

You can, however, split your ISA allowance between cash ISA, investment ISA and innovative finance ISA if it doesn’t exceed the yearly allowance (currently £20,000).

It doesn’t make much sense, I know. Still, splitting your yearly contribution between two stocks and shares ISAs may result in you losing the tax benefit on one of them.

In brief: You can have more than one stocks and shares ISA but can contribute to only one of them during a tax year.

Rule 4: How risky is a stocks and shares ISA?

There are risks involved in very investment.

Your stocks and shares ISA is exactly as risky as the investments you have in it.

You could learn more about the risks that investing inevitably presents here.

In brief: Stocks and shares ISAs are as risky as the investments within them.

Rule 5: How to calculate stocks and shares ISA fees?

It seems to me that most people miscalculate the fees they pay for their stocks and share ISA.

It took me some time to realise that providers charge three kinds of fees:

  • Fees for administering your account;
  • Investment fund costs; and
  • Market spread costs.

For years I thought that my stocks and shares ISA fee is 0.75% when in fact it is 0.95%. Doesn’t look much but it all adds up. And it is always good to know how much you ISA costs you.

In brief: Always check for fees above the management fee for stocks and shares ISA.

Rule 6: Can I have a joint stocks and shares ISA?

Here things are simple:

ISA is an individual account and you cannot open one in joint names or for someone else.

That’s it.

If you are concerned about what happens to your investment when you are gone, refer to the second little known rule of stocks and shares ISA.

In brief: ISA is an individual investment account and it cannot be under more than one name.

Rule 7: Can I open a stocks and shares ISA with poor credit score?

Yes, you can.

There have been people believing that ISA providers refuse to open accounts on the grounds of poor credit score. This is not likely – your credit score is important when you want to borrow money, not when you save money.

In brief: Yes, you can open a stocks and shares ISA with poor credit score.

Conclusion

ISAs were to be a simple instrument to encourage ordinary people to save and invest. However, since their humble beginnings the complexity has grown.

I hope this comprehensive guide to ISA helps you find your way around them and select the right one for you.