There’s one week to go until the bank holiday and I’m sure everyone that subscribes to the Weekend Read is terribly excited about the prospect of the new tax year which will accompany it.
Why is that?
Well, a new tax year brings with it a new stocks and shares ISA allowance and thus the opportunity for you to have a think about how you want to invest with the much-beloved tax efficiency that such an account would bestow upon you.
Subscribers to our Honey newsletter will have already seen the top 10 ISA stocks piece we published a couple of days and we thought we’d use that to try and give you some things to think about before April 5th.
But before we begin, you may have read the above and thought, “what is a stocks and shares ISA and why are you telling me about it?”
These are both reasonable questions to ask.
A stocks and shares ISA is an investment account that lets you invest your money and have it remain tax efficient.
I say ‘tax efficient’ and not ‘tax free’ because it’s a common misnomer that ISAs mean you owe nothing to the taxman. Even in an ISA you have to pay stamp duty on a lot of UK trades and US authorities will tax any dividends you receive from companies listed there.
Having said this, you won’t pay capital gains tax — that’s any money you make from buying and selling stocks — on ISA investments. And any dividends or other income you receive from UK-listed firms also won’t be subject to tax.
You may think this is great and rush to open an ISA. But the caveat here is you can’t deposit as much money as you like.
Every tax year you have an allowance, an amount set by UK authorities, which places a limit on how much you can invest in a stocks and shares ISA over the course of that 12 month period.
For now, our annual ISA allowance is £20,000 and that’s going to be the same when the new tax year begins on April 6th.
And with that brief intro out of the way, we can move on to our ISA tips.
This may seem like an odd question but one of the things people often do with an ISA is weigh up its tax benefits versus the tax allowances they have.
Outside of an ISA, you still have an annual capital gains and dividend tax allowance. For capital gains it stands at £12,300 and, for dividends, it’s £2,000.
Those are decent amounts and it makes some people wonder what the point of paying fees for an ISA is if they can get their allowance for free anyway.
The simple answer to this is that if you’re investing for the long-term it becomes much less of a headache to manage your tax liabilities in an ISA.
There’s also no telling where your investments will go.
The last place you want to find yourself is with an extremely well-performing portfolio, worrying about paying tax on those gains. Investing through an ISA in the first place means not having to penalise your gains later on.
This is a really simple point but one that a surprising number of people aren’t aware of.
You cannot carry across your ISA allowance from one year to the next.
So if you deposited £10,000 this tax year then you will not have a £30,000 allowance next year. The remaining £10,000 allowance you had is gone.
And if you’re thinking that you don’t know what to invest in right now, don’t worry.
If you want to make sure you use your 2020-21 tax allowance to the full then you can just deposit cash for now.
Be aware that cash drag is a real thing though, so don’t let time erode the value of your money.
Bear in mind that we are now just over a week away from the end of the current tax year, so if you are going to use up your allowance then you don’t have much time left to do it.
ETF managers have two options when they receive income from the firms they’ve invested in. Either they can distribute those dividends to people holding the ETFs or they can reinvest them back into the companies they hold.
This may not seem like a big deal but whether or not you reinvest dividend income can have a substantial impact on your overall return.
As we noted earlier this week, GFM Asset Management research found that 75% of investors’ return on an S&P 500 investment from 1980 to 2019 would have come from income reinvestment.
The lesson here is that if you are going to invest in ETFs, which is by no means a bad thing to do, think about whether or not you want any income reinvested or paid out as a dividend. If you have no plans for any income then it may be worth considering the former.
Investing for the long term in good companies is almost guaranteed to make you more money than making short term punts on Reddit stocks.
This is true in general but it’s particularly relevant for an ISA.
As the above example with the S&P 500 shows, the tax benefits of an ISA really accrue over a prolonged period of time. Okay it doesn’t have to be 40 years but it could just as easily be 5, 10 or 20.
And over those long periods, the larger gains you may see could show you just how valuable the tax efficiency is.
That being the case, it seems wrongheaded to invest money on punts like GameStop.
This is something that’s likely to lose you money anyway but if you are feeling particularly determined to do it, why bother using up your ISA allowance on it?
Ultimately an ISA is ideal for planning to hit a financial goal of some description. Maybe you’ll use it for a big purchase like a house or car. Alternatively you may add to it until you reach retirement. You can even do both.
Whatever your goal is, the point is that these are serious, long-term aims. Why spoil that with needless, short-term risk?
One of the big ISA pain points of the past was dealing costs, fees charged to you for making a trade.
This is particularly true for small amounts. If you have to pay £10 for a £100 trade then you have to make at least a 10% gain before you can even break even. And you’d probably have to pay the same on the way out too.
Beyond how annoying that obviously is, this presents you with a couple of equally irritating choices.
You can either cough up and invest in one go to cut your dealing fee (or you can’t if you don’t have the lump sum to hand).
Alternatively you can continue to invest each month and get hit with a dealing fee every time.
Now imagine a provider that doesn’t make you pay a dealing fee. Boy would that be crazy.
Yes you’d still have to pay foreign exchange costs on securities not listed in GBP but the lack of specific dealing fees would make regular payments and investments much more doable.
And doing so fits into that slow but steady gains formula which ISAs are so useful for. You don’t have to dump in a load of cash and invest it immediately, you can build it up over time.
Ultimately that’s what ISAs are really great for.