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This ISA season, is cash really king?

  • 28 February 2020
  • 15 minutes
  • It’s almost ISA season

  • Not only for you but also, potentially, for your children

  • But are you making the most of your tax-free opportunities?

ISA season is close upon us again, that time of year when we are nudged to check we have made the most of our tax-efficient savings. As a reminder you can save up to £20,000 in an ISA this year so you have until 5th April to top up your 2019/20 ISA.

As well as your personal allowance, you can also help your children by opening a Junior ISA in their names or giving them money to invest in a Lifetime ISA or a traditional ISA if they are over the age of 18.

Bear in mind that you can only gift £3,000 a year in total [2], although if one of your adult children is getting married or entering a civil partnership you can gift an additional £5,000. Grandparents, great grandparents and other friends and relatives can also contribute although different limits apply when it comes to wedding/civil partnership gifts.

If anyone gives a significant sum, they will need to prove this has come from “surplus income” or it may fall within their estate when their inheritance tax bill is calculated.

Read more: inheritance tax a complex labyrinth.

Tax treatment depends on the individual circumstances of each client and may be subject to change in the future.

ISAs in numbers

Over the past 20 years savers have put £870 billion into ISAs and saved an estimated £30 billion in income tax [3].

Cash ISAs have traditionally been viewed as one of the safest ways to make your money work harder. When ISAs were first introduced take-up was pretty much split equally between Cash ISAs (43%) and Stocks and Shares ISAs (57%). But over time, there has been an increasing trend in favour of Cash ISAs so that by the end of the 2016/2017 they represented 75% of the ISA market [4].

Cash is not king

Before the financial crisis erupted in 2007 it was possible to get a respectable return from cash. However, since the start of 2008, central banks – including the Bank of England – have kept interest rates low to encourage consumers spending and businesses investing. Whilst this has been good for borrowers, it has been bad for savers.

Even Cash ISAs launched with headline-grabbing rates of interest revert to standard rates after the first year, with some paying as little as 0.15% in interest [5]. You can earn more in a standard deposit account, albeit the income is taxable.

And if you decide to transfer to a new provider at the end of that first year you could find the potential earnings advantage wiped out by exit fees and penalty charges [6] especially if you have taken out a fixed-term Cash ISA

Inflation: the spectre at the feast

One powerful reason for not holding cash is the likelihood of it losing value due to the effects of inflation: the change in the prices of goods and services over time. Chart 1 below show the effect different levels of inflation can have on the value of cash.

Whilst inflation has been close to 2% for much of 2019 it was as high as 3% as recently as January 2018 and was 5% in October 2011 [7]. Combined with low interest rates, however, even this level of inflation means Cash ISAs are effectively losing value.

Which brings us to an interesting question: how much tax benefit are Cash ISA investors actually gaining?

All UK-regulated current or savings accounts and cash ISAs in banks, building societies and credit unions are protected by the Financial Services Compensation Scheme (FSCS) up to a maximum value of £85,000 per person per institution.

What’s the alternative?

Since 2000 Stocks and Shares ISAs have returned fifteen times as much as Cash ISAs, despite two of the biggest stock market crashes in history: the bursting of the dotcom bubble in 2000 and the global financial crisis in 2008 [8].

According to average Cash ISA savings rates collated by the Bank of England, £1,000 put into the average Cash ISA at the start of the 1999/2000 tax year would have been worth £1,183 by the end of the 2019, but this is worth only £1,066 once the effects of inflation are taken into account. An increase in real terms of £668 [8].

That same £1,000 invested in the FTSE All Share over the same period would be worth £2,788, or around £2,022 after inflation but before fund charges. A real increase of £1,022.

With any investment you should bear in mind that past performance is not a reliable indicator of future results. The value of investments and the income from them can fall as well as rise and is not guaranteed, and you might not get back your initial investment.

But while the returns from stocks and shares have been higher, they have also fluctuated widely with many sharp falls and rises (called volatility). Cash returns have been a more stable but have lost value in real terms.

Taking a balanced approach

Most discussions around ISAs focus on a decision between cash (low risk low returns) and equities (high risk high potential returns). But there is an in-between solution. Diversified funds and portfolios invest across a range of asset classes to reduce the extreme highs and lows to smooth out performance. They do this by spreading investments across a number of different assets such as equities, bonds, and property both at home and abroad. This seeks to reduce exposures to the different types of risk unique to each asset class.

Diversification allows you to optimise the amount of return you can potentially achieve given the amount of risk you want to take.

The aim is to counter the negative performance of some investments by the positive performance of others. This is because different investments perform well in varying economic and market conditions and asset classes tend to react differently to the same economic or political events.

Conclusion

ISAs are an important tool in our arsenal of tax efficiency, and can play an important role in helping us fulfil our long-term goals and aspirations. But when deciding how to invest your ISA allowance, think about your objectives for saving.

A Cash ISA could be for you when:

  • you are saving towards a short-term goal

  • you want to set some rainy-day money aside but don’t know when you’ll need it

A Stocks and Shares ISA could be for you when:

  • you aren’t looking for immediate access to your money and can keep it invested for around 10 years and at least five.

  • you’re comfortable with the fact that the value of your investments will go up and down and that you might get back less than you invested.

Speaking to a financial adviser can help you create a plan that structures your savings – and your wealth in general – to help you get from where you are today to where you’d like to be in the future.

They can explain all the different approaches available to you and help you plot the most appropriate path for your specific needs.

Important information

Any views expressed are our in-house views as at the time of publishing.

This content may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.

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Sources

[1] Money advice service correct as at 24 January 2020

[2] https://www.gov.uk/inheritance-tax/gifts

[3] https://www.thetimes.co.uk/article/a-brief-history-of-isas-in-facts-and-figures-zh00dwvqs 20 March 2019

[4] https://www.cityam.com/cash-vs-stock-market-difference-returns-since-isas-began/

[5] https://www.thisismoney.co.uk/money/saving/article-7551829/Three-four-biggest-High-Street-banks-slash-cash-Isa-rates.html 8 October 2019

[6] https://www.telegraph.co.uk/personal-banking/savings/fined-844-switching-isa-higher-rate-banks-get-tough-savings/

[7] FXStreet correct as at 27 January 2019

[8] Bloomberg, Schroders Personal Wealth as at 28 January 2020

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