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EnergyISA masterclass #3: how do ISA tax benefits work?
Filed under: Savings & ISAs
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ISA protect your investments against tax, but how does they actually work?Each day this week we're taking a closer look at the Fool's favourite tax-efficient savings shelter. Join us for our ISA masterclass!
Last time we saw that there are two kinds of ISAs -- cash ISAs, and stocks and shares ISAs, and we saw what kinds of investments you can put in each.
Your guide to banking
Money-saving guide
Need to know: Savings
This time we'll examine how the tax benefits actually work.
Cash ISA
If you save cash in an ordinary savings account and you're a taxpayer, basic-rate tax (currently 20%) will be deducted from your interest before it is paid to you. In addition, if you're a higher-rate or additional-rate taxpayer, you'll have to declare all of your interest on your annual tax return, and pay any extra tax that's due.
But if your money is held within a cash ISA, what you have to do is -- absolutely nothing! No tax will be deducted from the interest paid into your account, and you won't be liable for any higher-rate tax on it at tax-return time -- in fact, you don't even have to mention your cash ISA on your tax return. It literally couldn't be easier.
Stocks and shares ISA
Stocks and shares ISAs are just as easy to deal with concerning tax, as you don't have to pay any tax on your investments... and don't even have to tell the tax man anything about them either, just like cash ISAs.
There is, however, one trick to watch out for -- interest earned on cash balances held in stocks and shares ISAs is paid with 20% tax automatically deducted, and you can't claim that tax back.
Income tax vs CGT
You might want to arrange your share investments to make best use of your tax allowances outside of your ISA, because different profits from shares fall into different categories of tax.
You see, dividend payments are normally subject to income tax at your marginal rate, which might be as high as 40% or 50%, while increases in the capital value of your shares or funds when you come to sell them are taxed at the capital-gains rate, which is currently 28%.
As such, if you're a higher-rate taxpayer you might, for example, want to use up your personal capital-gains allowance each year by investing in some low-dividend 'growth' shares outside of your ISA, and use your ISA allowance for high-dividend shares to save any additional income tax on those dividends.
Alternatively, if you're a basic-rate taxpayer you might prefer to keep low-growth, high-dividend shares outside of your ISA, and use your ISA allowance to protect yourself against capital-gains tax on growth shares.
How you arrange your investments depends on your personal circumstances and tax band, though it only really matters if you are in a position to invest more than your ISA allowance every year.
What's next?
If you have any questions on what we've covered today, just ask in the Comments section below and we'll do what we can to help. Next time we'll compare regular savings with investing lump sums.
Cash ISA
If you save cash in an ordinary savings account and you're a taxpayer, basic-rate tax (currently 20%) will be deducted from your interest before it is paid to you. In addition, if you're a higher-rate or additional-rate taxpayer, you'll have to declare all of your interest on your annual tax return, and pay any extra tax that's due.
Your guide to banking
Money-saving guide
Need to know: Savings
But if your money is held within a cash ISA, what you have to do is -- absolutely nothing! No tax will be deducted from the interest paid into your account, and you won't be liable for any higher-rate tax on it at tax-return time -- in fact, you don't even have to mention your cash ISA on your tax return. It literally couldn't be easier.
Stocks and shares ISA
Stocks and shares ISAs are just as easy to deal with concerning tax, as you don't have to pay any tax on your investments... and don't even have to tell the tax man anything about them either, just like cash ISAs.
There is, however, one trick to watch out for -- interest earned on cash balances held in stocks and shares ISAs is paid with 20% tax automatically deducted, and you can't claim that tax back.
Income tax vs CGT
You might want to arrange your share investments to make best use of your tax allowances outside of your ISA, because different profits from shares fall into different categories of tax.
You see, dividend payments are normally subject to income tax at your marginal rate, which might be as high as 40% or 50%, while increases in the capital value of your shares or funds when you come to sell them are taxed at the capital-gains rate, which is currently 28%.
As such, if you're a higher-rate taxpayer you might, for example, want to use up your personal capital-gains allowance each year by investing in some low-dividend 'growth' shares outside of your ISA, and use your ISA allowance for high-dividend shares to save any additional income tax on those dividends.
Alternatively, if you're a basic-rate taxpayer you might prefer to keep low-growth, high-dividend shares outside of your ISA, and use your ISA allowance to protect yourself against capital-gains tax on growth shares.
How you arrange your investments depends on your personal circumstances and tax band, though it only really matters if you are in a position to invest more than your ISA allowance every year.
What's next?
If you have any questions on what we've covered today, just ask in the Comments section below and we'll do what we can to help. Next time we'll compare regular savings with investing lump sums.
