As investors, it’s important that we think about our investment returns after the tax has been paid on them. After all, there’s no point focusing on pre-tax gains – it’s the cash we’re left with that matters.
That’s why I used last week’s Penny Sleuth to show how recent changes to the capital gains tax (CGT) regime have reduced the value of your shares if you’ve held them for a long time.
But there is a way you can build up a sizeable investment portfolio outside of the tax net. It has no CGT liability to manage and no extra tax on dividends for higher-rate taxpayers.
And it’s not a state secret either. It’s called an individual savings account (Isa) and there’s never been a better time to have one.
Last year, the Isa rules underwent a massive overhaul – one of the most important developments was that Aim stocks became eligible for inclusion for the first time. As most of my time is spent focusing on small caps, I was naturally pleased by this.
August marks the first anniversary of those changes to the Isa system, so I think now is an ideal time to look at their impact and explain why I feel that Isas should be a core element of everybody’s investment strategy.
Own a share without paying any tax
Happily, under the new rules, the Isa system has been simplified. And in fact, I should actually be calling them Nisas, or ‘New Individual Savings Accounts’.
Previously, there were distinct Isa products, one for cash and one for stocks and shares, each with different annual subscription limits. This distinction has been swept away, and old cash Isas can now be transferred into the new Nisa wrapper and used to invest in shares – if you want.
A word of warning though – if you want to transfer an old cash Isa to a new provider who lets you deal in shares as well, do not withdraw the cash yourself, hoping to add it to your Nisa account.
Once you have withdrawn funds from the tax-free wrapper, you can’t put them back in. You need to fill in a form asking your old provider to transfer the funds to your new Nisa account.
Another positive change is an increased £15,000 annual subscription allowance. When you consider the flexibility of being able to invest this sum in funds, gilts, corporate bonds, cash and shares, there’s really no reason not to have a Nisa.
As before, there’s no tax to pay at all on any income or gains earned within a Nisa. Previously, interest earned on cash balances held in a ‘stocks and shares’ Isa could be taxed, but that is no longer the case with the unified Nisa structure.
In this new regime, it’s now possible to own a share without paying any tax whatsoever. Aim shares no longer suffer the 0.5% stamp duty levied on the purchase of stocks with a full listing.
They can now be bought in a Nisa, where they’re free from CGT and income tax on dividends. And if they’re held for two years, most Aim stocks are free of inheritance tax as well, which is great.
Four things to keep in mind when investing in a Nisa
The only thing to remember is one of my golden rules of investing: Don’t let the tax tail wag the investment dog!
Experience has taught me that focusing too much on tax efficiency means you might not put enough emphasis on investment returns. After all, if your strategy doesn’t make any money, then you’re not going to be paying tax anyway!
So what’s the best approach for investing using the Nisa?
1. Use your full allowance if you can
If putting all £15,000 into stocks seems a bit risky in the context of your overall portfolio, or if you’re a bit bearish; you can keep some of your allowance in cash. The point is the allowance is an annual amount. If you don’t use it this year, you lose it.
2. Don’t stuff your Nisa full of speculative stocks
In order to benefit from the tax shelter, you need to make some positive returns in the first place. The only downside of a Nisa is that losses are just that – complete write-offs.
At least a loss in a taxable account can be used to offset gains made elsewhere and reduce your CGT liability. So I prefer to look for a balance of quality growth ideas together with a few higher-risk plays.
3. Don’t underestimate dividends
If you don’t need to withdraw the income, dividend reinvestment is a great way to build up the value of your tax-sheltered fund.
4. Think ‘total return’ rather than ‘capital and income’
When the time comes to take some cash from your Nisa you don’t have to worry about any tax implications. This means you can be indifferent between capital and income.
So, if you decide to take out £10,000 a year in retirement you don’t need to design a portfolio that generates that amount in dividends – which might well restrict your stock universe to high-yielders. You can cash in some capital gains as well as draw income, without the tax complications.
My Nisa experience
Looking at my own Nisa, I’m very pleased with the performance over time. There’s been the occasional dud, of course, but one big winner stands out. This is Next (NXT), which I bought in the late 90s when it had fallen out of favour.
Looking back, it was a classic example of buying a good company during a period of temporary disappointment. What I’m proud of isn’t the purchase, but the fact that I’ve held on to the stock for 16 years. As a result, it’s become my biggest holding after rising about 14-fold.
If I had held my Next shares outside of an Isa, I’m sure I would have been tempted to sell some or all of it along the way in order to manage my CGT.
So, not only does a Nisa save you tax, it also encourages a proper long-term view of savings and a pure investment approach – free from the distortions of tax considerations.
There’s really no excuse not to have one.