Incredibly, there are savers and investors out there who do not religiously open an ISA (or top up an existing ISA) every year in order to use up as much of their annual ISA allowance as they possibly can.
This is nuts.
ISAs are one of the best tax breaks going for the likes of you and me.
Tax might not seem a big deal when you’re starting out with investing. But over the long-term, paying too much tax can dramatically cut your returns.
It’s true that there can be modest fees for holding an ISA on some platforms. It doesn’t take much for the tax breaks to outweigh these tiny costs – maybe as little as £100 or so in dividend income if you’re a higher rate tax payer. Even these platform fees can be avoided if you simply open an ISA directly with a fund provider and invest in, for example, one of their cheap tracker funds.
But there’s another good reason to get into the habit of investing in ISAs.
Whatever you buy in an ISA and whatever gains you make from your investment – capital gains or income – is your business. You don’t have to tell HMRC about it and it doesn’t want to know.
Using ISAs for all your investments therefore sidesteps the horrors of paperwork that can build up if you invest outside of their lovely HMRC-shielded protection
Avoiding self-assessment paperwork with an ISA
I can think of plenty of places I’d rather not be at two o’clock in the morning.
Peckham, for example, or delivering pizzas in Kabul, Afghanistan.
But in my home office filing through old share trade notes to calculate my CGT situation for the taxman – that’s right up there with the war zones.
You have to declare details of your capital gains and losses from share trading over the past financial year if:
- You made more than your CGT allowance in capital gains in the year
- You made total disposals of 4x that allowance
Let me take you back to 2009.
I sold quite a few holdings in the tax year to 5th April 2009, recycling the proceeds into what I guessed judged were safer harbors during the bear market.
As you’d expect back then, this meant I realised capital losses. Even if I wasn’t bound by law to detail them to HMRC, I’d have done so anyway to carry the losses forward to set against CGT in future years.
But as it happened I did have to detail them, because my total disposals were beyond the 4x threshold.
For example, I sold my remaining bank shares in summer 2008, which looking at the prices I got for them seemed a lot cleverer/luckier in retrospect than it felt at the time.
Selling Lloyds shares for between £2 and £3 when I got cold feet about the merger with HBOS was hard, given they’d been over £6. But considering the share price fell to near 30p within 6 months, I thank whatever angel was sat on my shoulder that day!
Looking at other trades was equally painful; positions built up over years sold at less than cost, down from twice that level in 2007. (Note that I typically didn’t take the money raised out of the market. Selling low and missing the upturn is a classic bear market error; instead, the money my sales realised were recycled into other shares, trackers, and trusts. I was a net buyer during the bear market).
In short, share trading outside of an ISA was a lot of hassle and paperwork for a pretty uncertain return that year.
(Remember, it’s better to use a tracker folks!)
There’s hassle, and then there’s Sharebuilder
What made the CGT exercise even more tedious was that most of the shares I sold were located in a so-called Sharebuilder account that had held my high-yield portfolio.
Sharebuilder accounts seem a great idea, because they enable you to buy small bundles of shares at a much lower cost per trade (£1.50 in my case, now £2). You can even set them to automatically re-invest dividends, which at the time I was doing it incurred no commission fees at all.
The trouble comes when you have to calculate a taxable gain or loss on disposal. Then the Sharebuilder is an instrument of torture.
I had some positions built up from half a dozen more purchases or more over the years, including reinvested dividends.
This meant I had to tediously go through and collect all the transactions to calculate my total purchase costs.
With Sharebuilder, I also frequently ended up buying fractions of shares. This seems a lot less cool at 2AM when you’re staring at something like:
BT.A 23-Jan-04 BUY 269.3072 184.18 5-Mar-04 BUY 274.524021 180.68 20-Aug-04 BUY 136.464485 181.19 7-Sep-04 BUY 15.566294 184.18 14-Nov-04 BUY 249.38911 198.89 29-Nov-04 BUY 253.557919 195.62 8-Feb-05 BUY 22.261045 208.93 27-Oct-05 BUY 219.669073 203.67
Believe it or not, it got even worse.
The ultimate nightmare is when some shares were bought and sold multiple times over say a five-year period. Back in those days you had to work out how a pool of expenditure on the shares changed over time, in order to properly work out the capital gains or losses due. (Thankfully this element of CGT accounting has since been slightly simplified).
In short, paperwork like this is fiddly and boring and if you’re lucky you’ll never have to do it. (If you do and you’re stuck, check out the UK government page on tax arising from share transactions for more details.)
I spent a weekend digging through old trades and working out my gains and losses on disposal that year.
Whoever said share trading was glamorous?
ISAs and SIPPS saves all this hassle
Being free of this paperwork is another great reason for using a tax-exempt trading account to hold your shares.
ISAs and SIPPs (Self-Invested Personal Pensions) enable you to shelter your holdings free from income and capital gains tax – and also from all any paperwork.
These tax advantages are worth having. But the thing is, many people will take a few years to reach the stage where their investment will be generating serious dividend income. Or else they’ll invest in a tracker or other fund and allow it to grow without selling it.
They therefore wonder why they should bother setting up an ISA, especially if they have to pay a fee for it, since to they’re not getting much income or seeing capital gains in the early days.
But eventually through regular saving and reinvesting, dividend income will grow to be meaningful. When it does you’ll curse the unnecessary tax you’ll pay on your hard-earned investments.
Equally, deferring capital gains is great right up until you need to realise them and discover you owe the taxman a big slug of two decades worth of growth.
Yet even if these tax benefits take a while to show, avoiding paperwork is a bonus you get straight away when you open an ISA or a SIPP for share trading.
You aren’t expected to tell the taxman what you hold in an ISA – he doesn’t want to know. You can make gains and losses in your own perfect little ISA kingdom, free of the toll of the taxman.
I have about half my portfolio in ISAs and a little more in a SIPP. I started using tax shelters too late, and so will forever be playing catch up by moving my money into them (likely by harvesting capital gains on unsheltered holdings). I see little chance of me ever sheltering all my money within them, unless I stop earning and saving altogether.
If you’ve only recently started investing, you can avoid this sorry fate. Or, if you’re an old hand who is yet to open an ISA, bite the bullet and start sheltering your funds from tax today.
Remember the deadline for opening an ISA this tax year is April 5th.
Note: This article on reasons to open an ISA was updated in 2013 to reflect the current tax situation.