Using Isas to fund your retirement
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Could Isas overtake pensions as the UK’s retirement savings vehicle of choice?
When the tax-free savings individual savings accounts were launched by Gordon Brown in 1999, few would have expected them to become a serious part of retirement portfolios. Times have changed.
The tax benefits of pensions have been steadily eroded over the past decade, and there are growing fears that the new chancellor could have higher rate tax relief in his sights at the Budget next week.
At the same time, Isas have been coming into their own. In the 2017-18 tax year, the generous £20,000 annual allowance was subscribed to in full by 61 per cent of adult Isa investors earning more than £150,000, according to the latest data from HM Revenue & Customs.
That same group will have seen their pensions savings options whittled down by the annual allowance taper, which can restrict pension savings to as little as £10,000 per year.
Most people approaching retirement today will rely on a combination of pensions and Isa income to see them through, but the “topsy turvy” nature of their tax treatment and different inheritance tax concerns mean investors have to carefully plan how best to take income from both.
Taxing questions
Broadly speaking, pensions are not taxed on the way in, but on the way out — and the opposite applies to Isas.
The money you save into Isas comes from income that is already taxed — but once inside the Isa, your investments can grow tax free and withdrawals will not attract capital gains tax or income tax.
Furthermore, investment income generated by your Isa will not be subject to the dividend tax (outside an Isa, you pay tax on dividend income that exceeds £2,000 per year, charged at 7.5 per cent for basic rate taxpayers, 32.5 per cent for higher rate and 38.1 per cent for additional rate).
FT Money Isa Guide 2020
There is no limit on the total investments you can hold tax free within Isas — this is a significant advantage over pensions, which are subject to a lifetime allowance of £1.055m above which tax penalties apply.
There are a growing number of people in retirement who have built Isa portfolios worth more than £1m in value and can now enjoy tax-free income from their investments.
By contrast, any income taken from pensions after the 25 per cent tax free lump sum would be subject to income tax at your marginal rate.
Isa millionaires
The annual subscription limit for stocks and shares Isas has gradually increased over the 21 years since the tax-free accounts were introduced.
The maximum that could be invested in 1999 was £7,000, rising to a generous £20,000 per adult from 2017-18. Those who invested the full amount every year for the past 21 years would have subscribed £229,560 in total. However, the long bull run, combined with the power of tax-free compounding, means investment platforms report growing numbers of “Isa millionaires” — and this coveted status is within reach for many other investors.
At the end of February, Interactive Investor had 395 Isa millionaires, Hargreaves Lansdown had about 300 and AJ Bell around 30.
Interactive said the average age of its millionaires was 72 and they were likely to be at least semi-retired. “However, they are still invested across the asset spectrum, with less than half as much in cash as the average Isa customer,” says Rebecca O’Keeffe, the platform’s head of investment. “This demonstrates how active, engaged, successful investors tend to have historically taken more risk.”
So what do the millionaires have in their investment portfolios?
Analysis by Interactive found the average number of holdings was 34. The most popular shares included companies famed for their dividend income, including Royal Dutch Shell, GlaxoSmithKline, BP, National Grid and Lloyds Banking Group. Almost half (46 per cent) of the Isa millionaires had portfolios powered by investment trusts such as Alliance Trust, Scottish Mortgage, Witan, City of London and Law Debenture.
Ms O’Keeffe says Isa millionaires often prefer investment trusts over funds, noting their relative outperformance over the long-term.
Isa millionaires on the AJ Bell platform have also tended to shun funds, which made up just 3 per cent of total holdings of its 30 millionaires, with the rest held in shares, investment trusts and ETFs.
Almost half of AJ Bell’s millionaires hold shares in Lloyds — and more than a quarter of these successful investors are women, the youngest of whom is a mere 45 years old.
AJ Bell personal finance analyst Laura Suter says that, in general, the millionaires are likely to have a home bias and stick to UK stocks, with Aviva, National Grid, Tesco and SSE among the most popular stocks in the group. However, investors who favoured US tech stocks have enjoyed spectacular tax-free returns.
“The biggest gain among the group was an early investment in technology giant Amazon, with one savvy investor buying 60 shares when they were £19 a share — they have since soared to more than $2,000 (around £1,700) a share,” says Ms Suter.
“Other tech giants to propel the Isa millionaires’ returns are Google parent company Alphabet, bought for around £100 a share and returning more than 1,000 per cent, and Tesla, where the shares have risen by about 420 per cent during the time one Isa millionaire owned them.”
A large number of smaller UK stocks have delivered a strong performance. Plastic producer Victrex netted one Isa millionaire on the platform a 1,940 per cent return. Digital marketing supplier 4Imprint rose by almost 1,800 per cent during the time one millionaire owned it. Other more niche examples include Aim-listed iodine producer Iofina, which rose more than 1,400 per cent, and FTSE 250-listed polymer producer Synthomer, which jumped 585 per cent.
“The beauty of saving money in your Isa is that there’s no income tax or capital gains to pay on your growth, which would otherwise eat into your returns when you come to cash it in,” Ms Suter adds.
“This means that if you reach the lucrative Isa millionaire status, then without even touching your capital you could feasibly take a £40,000 income each year, entirely tax free, assuming a 4 per cent yield on your pot — more than the average UK salary before tax.”
Hargreaves Lansdown says that more than 300 of its clients are Isa millionaires. Many of them have been investing for more than the 21-year lifespan of the Isa, as they rolled over personal equity plans (Peps). This is how Lord Lee, the FT columnist who claims to be the UK’s first Isa millionaire, managed to hit the magic number in 2003.
Hargreaves said its Isa millionaires also tended to focus on dividend-paying companies and dividend-focused funds.
As the savings account comes of age, the prospect of more Isa millionaires beckons.
Investors who start investing the maximum £20,000 today could hope to see their investments grow to £1m in value over the next 25 years, says Ben Yearsley, chair of the investment committee at Shore Financial Planning.
“The £20,000 a year annual allowance is very generous and builds very quickly to a sizeable pot, he says. “If your pot is growing at seven per cent a year, the money doubles over 10 years.”
Flexible income from Isas
Shore Financial Planning advises many clients born between the 1940s and 1960s who have significant Isa and pension savings, as well as investments held outside Isas. Mr Yearsley says the first thing people of this age group should do is work out their income requirements in retirement, then look at how to fund these in the most tax-efficient way possible.
“They can take 25 per cent tax free from their pension pots; they can also use the annual capital gains tax allowance of £12,000 to make disposals [on non-Isa investments] and then take a big part of their income tax-free from Isas,” he says.
Assets are transferable between married couples and civil partners free of CGT, which means that both can use the annual CGT allowance, but any gains beyond this would be subject to tax at 10 per cent for basic rate taxpayers, rising to 20 per cent for higher rate and additional rate taxpayers.
Sarah Coles, personal finance analyst at Hargreaves Lansdown, says the flexibility of Isas can make them incredibly valuable to hold alongside a pension in retirement.
“One of the best strategies for drawing income in retirement is to invest [your Isa] for income, and then draw the natural yield,” she says. “This means you are only taking the income actually produced by your investments and not nibbling away at the capital. Isas can actually be set up specifically to pay away the income.”
Those who plan to phase retirement before the age of 55 can supplement their income from Isas until pension benefits can be accessed.
“You may choose this option after the age of 55 too, especially if you want to keep paying substantial sums into your pension,” Ms Coles adds. “If you take money from your pension you trigger the Money Purchase Annual Allowance (MPAA) which means you can only pay £4,000 into your pension tax efficiently each year. By topping your income from Isas instead, you’ll keep the full pension annual allowance.”
By balancing how you take income from Isas and pensions, you can control the tax you pay. After taking the 25 per cent tax-free cash from your pension, you can avoid paying the 40 per cent higher rate tax by taking pension income up to the £50,000 threshold and then tax-free Isa income on top, Ms Coles says.
However, the tax benefits are not the only thing investors have to think about. Investment risk and longevity risk must also be carefully considered — something that recent market volatility has underlined.
“If you have invested for income, you may be less concerned about fluctuations in the overall capital value as you are investing for the long run,” Ms Coles adds.
However, she cautions that investing in individual income-focused shares is more risky, because Isa investors will be exposed to any fluctuations in the dividend.
“The risk when you are accumulating assets tends to be about investment risk, but when you are drawing down your assets, the risk turns to longevity risk and whether your assets will provide you with enough income throughout your retirement,” explains Interactive’s Ms O’Keeffe.
In theory, the main reason to favour income over growth as you approach the point at which you start to draw down your investments is to reduce the risk of the portfolio, not to secure an “income”, she says. Hence investors need to be sure that choosing income over growth is genuinely a reduction in risk.
“Over the past few years the opposite has been true — big growth companies and tech companies have been relatively ‘safe’, while high-dividend companies have actually been especially risky,” Ms O’Keefe notes. “There are plenty of examples of shares whose high dividends have been a sign of imminent demise, so investors need to think carefully about whether a stock that is paying a high dividend is a good choice.
“As your investment horizon shortens, so your appetite for risk is inevitably reduced. So it certainly makes sense to begin moving a portion of your portfolio into less risky equities, bonds, precious metals, or to go for greater diversification in order to reduce risk.”
However, some investors may be tempted to place some of their Isa investments in riskier assets to take advantage of inheritance tax benefits.
An eye on inheritance
If investors expect to leave significant sums after their death, they should consider where they take their retirement income from, as pensions and Isas are treated very differently on death.
Certain types of pension can be passed tax free to your heirs if you die before the age of 75. Beyond this, they will be subject to income tax at the beneficiary’s marginal rate.
Isas can be passed tax-free between spouses or civil partners after the first death, but are subject to inheritance tax after that — with the exception of certain qualifying shares traded on London’s Alternative Investment Market. If held for more than two years, these can be passed on tax free under business property relief (BPR) rules.
When starting to access retirement income, those with funds in both an Isa and a pension are often advised to leave defined contribution pensions until last “from a pure inheritance tax perspective”, Ms O’Keeffe says.
However, Mr Yearsley notes the growing trend for Isa investors to build portfolios of Aim-traded shares, many of which come in the form of ready-made portfolios from specialist providers. Some £435m flowed into IHT Isas offered by the 15 main providers in the 2017-18 tax year, according to HMRC data.
“Some Alternative Investment Market shares held for two years can be passed on IHT free, but there is volatility and they may not be easy to sell in a falling market,” he adds.
As well as liquidity concerns, there is also a risk that the beneficial tax status could be culled at a future Budget. Last year, the Office for Tax Simplification questioned the “policy intent” of extending BPR relief to Aim shares, but stopped short of recommending further action.
Ms Coles adds that while not all Aim shares qualify for the inheritance tax exemption, they are not suitable for everyone. “You need to understand the level of risk involved and make sure it is right for you,” she cautions. “If inheritance tax is a concern, it is worth looking holistically at planning opportunities, and ensure you are making the most of your gifting allowances and considering larger gifts at the time that suits you.”
Overall, the potential tax savings of combining income from Isas and pensions for those approaching retirement are substantial.
Yet if you’ve been lucky enough to reach the coveted Isa millionaire status, don’t shout about it too loudly — there’s a danger a future chancellor may hear you.
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