For example, cash ISAs pay their interest free of income tax. If you decide to invest in fixed income through your ISA, you also pay no income tax. In addition, although interest-paying fixed income funds pay 20% tax on the interest up front, these qualify for a tax credit, which will then be refunded to you. So these two asset classes, while carrying different levels of risk, are completely free from income tax.
Bonds carry a higher risk than cash as their capital values and income levels can fluctuate. Some bond funds give exposure to UK Government bonds (known as gilts), which are thought to have a lower risk of default. Investors can access gilts through a gilt-only fund or by investing directly. Note, however, if you do go direct, these gilts must have at least five years to run until maturity to qualify for your ISA. Further up the risk scale, investors can look at investment grade corporate bonds, which are issued by major blue-chip companies, or global government bonds, such as from the US or eurozone. Among the most risky fixed income investment are so-called ‘high yield’ bonds, which invest in smaller or weaker companies.
For income tax alone, using an ISA to invest in stocks and shares can be less tax efficient. There is a 10% tax deduction on all UK dividend payments taken at source that, since April 2004, cannot be refunded even within an ISA. As a result, basic rate taxpayers see no additional income tax gain from investing inside or outside an ISA. Higher rate taxpayers, however, who would normally have to pay additional income tax on the dividend income they receive from shares are sheltered from any additional liability.
It is worth noting while stocks and shares are seen as higher-risk investments, the asset class has traditionally delivered higher total returns than bonds or cash over the long term. The fact no Capital Gains Tax is payable on ISA gains could therefore be an advantage.
Paul Dixon FPFS
Chartered Financial Planner
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Census Financial Planning is an independent financial planning practice providing a professional and comprehensive financial planning service, located on the Lisburn Road in Belfast, Northern Ireland.