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Common ISA Misconceptions Part II: Taxation

"ISAs are Inheritance Tax-free" and other common misunderstandings regarding the tax benefits of ISA investing

Morningstar.co.uk Editors 15 February, 2011 | 9:15AM

Even though an ISA is simply a tax-efficient wrapper, it can be somewhat difficult to wrap one’s head around the tax benefits it offers. Misconceptions are particularly prone to arise in when comparing Individual Savings Accounts with other types of tax-efficient vehicles, namely, pension schemes.

In the second article of our week-long feature on common ISA misunderstandings, we tackle some of the most widespread confusions regarding the tax benefits of ISAs.

1.I'm better off putting money in my pension because of the tax relief
Whether you should put your savings towards a pension scheme or an ISA-eligible vehicle is an ongoing debate with far from a single answer. It largely depends on the goals and needs of each investor, so it can be a good idea to seek the advice of a financial professional.

Saving towards retirement, whether in a personal or an occupational pension, offers tax relief at your highest rate on contributions of up to 100% of your annual earnings (subject to a £255,000 cap). That is, the UK government will refund the income tax you paid on up to £255,000 of your income if allocated towards a pension plan (this amount will be reduced to £50,000 in April, but some pension schemes might have adopted the new tax levels already).

In addition, many employers offer to match pension plan contributions, which is effectively offering a pay rise and well worth taking advantage of: failing to take advantage of maximum employer contributions is failing to take advantage of free money. The nature of the tax rebate system means that it’s higher earners that tend to make the most of these pension advantages (up to salaries of £100,000).

Pension contributions, however, are not accessible for long periods of time, currently until one reaches 55. In that respect, ISAs offer much more flexibility. When considering your options for retirement savings, it is also worth noting that the long lifetime of a pension plan contribution means that it might be more susceptible to changes in state policy. Thus keeping up with regulatory changes or seeking the help of a professional adviser to help you do so is important.

Read this case study for more insight into the topic.

2. ISAs are Inheritance Tax-free
No, they are not. The assets you hold within an ISA wrapper will be added to the value of your estate and you will be eligible to pay tax on any amount in excess of the IHT threshold, which at the moment is £325,000.

The impact of an ISA account on your IHT bill can become more palpable with time if savings in your ISA accounts accumulate. Again, to be sure it’s best to speak to your financial adviser.

3. I don't need an ISA, I don't pay higher rate tax
Any individual who pays income tax stands to benefit from saving and investing in an ISA. All these tax-efficient wrappers give is the opportunity to not incur income tax or capital gains tax, irrelevant of which earnings bracket you fall into, on any income or gain received from savings or investments in an ISA. Resulting dividends and interest are free from income tax and capital gains are free from capital gains tax. Note, however, that dividends are subject to a one-off tax of that cannot be reclaimed.

To make life simpler, you don’t even need to declare an ISA on your tax return.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Morningstar.co.uk Editors  analyse and report on shares, funds, market developments and good investing practice for individual investors and their advisers in the UK.