What you need to know about Isas and penny shares

The latest Budget completely changed the game for savers. You’ve probably already heard about the most dramatic changes, which were to do with pensions and annuities. But direct investors in equities got some help too.

Over the winter people were speculating that the government was about to cut back on Isa tax breaks. This was in response to ‘concern’ over the fact that some savers had invested skilfully over many years to amass an Isa pot worth over £1m. I’m not sure whether concern is the right word here… maybe ‘envy’ is more accurate! Only in the UK would someone who successfully invested money on which they’d already paid income tax, be regarded as a source of concern.

The fact is that the Isa tax breaks are relatively small. And as it turns out, the speculation was completely wrong. In his “Budget for savers” the chancellor didn’t fiddle with the rules, but actually simplified them.

I’m a fan of Isas and think every equity investor should use them. So I’m going to run through the new rules and tell you how I think we should approach investing within an Isa ‘wrapper’.

Before I start though, allow me to quickly run through the basics of investing in Isas. Isa stands for Individual Savings Account. It’s a government scheme which is designed to encourage individuals to invest their own money, which is why investments in an Isa pay no tax on capital gains, interest or dividends. Isas can be used to hold shares, unit trusts and cash, up to a given annual limit – but that limit is soon to be raised.

£15,000 a year of tax free investments

Osborne announced that the annual limit for Isa subscriptions is to be raised to £15,000. We can subscribe £11,880 now, and then bring the total up to £15,000 when the new rules come in on 1 July. The old distinction between the cash Isa and the stocks & shares Isa is also to be removed. All existing accounts will be re-branded as New Isas (Nisas), and we will be able to apply the full £15,000 to whatever combination of cash and shares (including penny shares) we want.

Because cash Nisas and shares Nisas are now treated equally, we will be able to transfer all our shares Isa into a cash Nisa — which wasn’t previously allowed. This might be useful for retirement planning (or if we feel very bearish). We can reduce our equity exposure but keep it in a tax-free account; which will be helpful if interest rates ever return to worthwhile levels!

The main benefit of Nisas is that shares held within the account are shielded from capital gains tax (CGT). So if you’ve done well and built up some decent profits, you can trade freely without worrying about the tax implications of a sale. Outside a Nisa, this tax year’s allowance for CGT is £11,000. Gains above that level are taxed at 18%, or 28% if you are a higher rate taxpayer. That tax free allowance of £11,000 isn’t bad, but remember there is no inflation or taper relief to reduce your gains nowadays.

Let’s take an example. Imagine you bought £10,000 worth of dotDigital (DOTD) when it was recommended in Red Hot Penny Shares at 13p just over 18 months ago. Today the shares would be worth just over £26,000, giving a £16,000 profit in round numbers. For a higher rate taxpayer, this would result in a bill from HMRC of £1,400. If you’d already used up your annual CGT allowance, the bill would be higher still. So your net profit after tax would be £14,600. But if you’d invested in dotDigital using a Nisa, you’d keep the full £16,000.

The last benefit of a Nisa is that, for higher rate taxpayers, there’s no extra tax to pay on dividends received in a Nisa wrapper. Those 40% taxpayers have to pay 25% of the value of net dividends received, so this is a worthwhile saving.

The right penny shares for your Nisa

As well as the tax benefits, I like Nisas because they encourage a disciplined, regular approach to savings. If you don’t use your allowance in a given year, you lose it – and I hate losing a tax break! And as ‘Isa millionaires’ have shown, if you invest well for a long period you can build up a tidy sum.

However, one important thing to remember is that you can’t use any losses made in a Nisa to offset taxable gains made elsewhere. So try to put your winners in the Nisa and hold your losers outside it. On a more serious note, it’s frustrating to book a loss and not be able to apply it to your CGT bill. Similarly, if you have a big winner in your Nisa it’s really helpful not to have to worry about any tax implications.

Therefore I think it’s a good idea to aim for a balanced approach. Try not to fill your Nisa solely with high-risk speculative situations. By all means hold some there, but I also like to have a good exposure to what I regard as higher quality, long term growth names. This way I make sure of benefiting from the tax shelter to some extent.

Readers of Red Hot Penny Shares will know my preferred share recommendations for long term growth I’d consider for your Nisa.

Finally, I want to remind you that we’ve also just received another tax break. On 28 April, stamp duty, which is levied at 0.5% on share purchases, was removed from deals in Aim shares. This follows on from Aim stocks being permitted in Nisas from last year. As the advert says, “every little helps”.

If you’re not already using Red Hot Penny Shares as part of your research into AIM and small cap growth shares for your Isa, then read more here about how to register and claim a 90-day trial today.

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