The one problem with Isas, and how to avoid it

I love Isas. The government has muddied their waters a little over the past few years with the introduction of complicated and unnecessary new versions of them the Lifetime Isa, the Help to Buy Isa and the Innovative Finance Isa. But the original idea is both simple and brilliant.

You set up the Isa wrapper via your favourite investment platform or wealth manager. You put in up to £20,000 a year, and that's that. You can invest in any shares or corporate bonds issued by companies listed on a recognised stock exchange anywhere in the world, in gilts or other government securities, in all UK authorised funds and even in some life insurance policies.

Once safely inside the Isa, your investments will grow free of all taxes (capital gains and dividend taxes being the relevant ones) until you take them out. Put the maximum in with your partner every year for the next 17 years, assuming an average annual return of 5% (not madly ambitious by historical standards) and you'll have a million pounds by the year 2034.

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What's not to like particularly if, like many high earners, you find that your attempts to build a huge pension pot have been hampered? The lifetime allowance governing what can be saved tax-free into a pension has come down to £1m, and don't get me started on the tapering of the annual allowance, which is now a measly £10,000 a year for the highest earners.

The trouble with Isas

One potential wrinkle is inheritance tax (IHT). Unlike assets held within your pension wrapper, those within your Isa wrapper are liable for IHT. True, your Isa can now pass tax-free to your spouse or civil partner upon your death. But when time is up for both of you, it cannot be passed tax-free to your children.

I am never entirely sure why death taxes cause the living so much anxiety (they'll be long gone when the bill comes in). But they clearly do. Ask any wealthy person over the age of 70 what keeps them up at night and there's a good chance IHT will feature somewhere in the answer.

There are a couple of very easy solutions to at least part of this IHT problem: spend your unneeded money, or give it to your kids now.

There is an interesting study to be done (please let me know if you have already done one) into how much of the capital kept inside Isas is actually taken out and spent every year. The official statistics don't break this down.

Flicking through the data, you get the sense that it's not much. The over-65s have vastly higher average amounts held in Isas than even the 55-64s, and lots of them keep contributing into Isas well into their retirement as well. There is no sign they are decumulating.

You will say this is prudent and sensible of them. I would say it slightly misses the point of saving in the first place. If saving is deferred consumption, never actually doing the consumption bit (or giving the cash away so someone else can) seems a bit of a shame. Still, if you must hang on to your money, you do have it in an Isa and you are firmly convinced that IHT is the devil's work, then what should you do?

Score a tax-free hat trick with Aim stocks

You could shift the investments inside your Isa wrapper into stocks listed on Aim (designed for small and entrepreneurial companies). In 2013, the Isa rules changed to allow Aim-listed shares to be held inside an Isa. This matters, because lots of Aim stocks though, crucially, not all of them are eligible for Business Property Relief (BPR) when held for more than two years. Transfer into these, and your portfolio will score a tax hat trick free from liability to dividend tax, capital gains tax and inheritance tax. Nice.

Strictly speaking, I do not approve of making investments for tax reasons. There are three obvious disadvantages to the Aim route. The first is the legislation on relief itself. You might wonder exactly how a future Corbyn government might look at BPR. As a form of tax relief that in essence allows families to hand down businesses and share portfolios intact to their heirs, is this a driver of inequality, or a perk for the rich? Experts have already expressed concerns about its vulnerability.

The second is valuation. Look at a chart of Aim stocks before and after their Isa eligibility was confirmed and you will see that they have become considerably more expensive in price/earnings terms since then (I'm putting this on Instagram for you follow me @moneymerryn). You can argue and Aim fund managers certainly will that there are other reasons for this strong performance, but to my mind there is no doubt that the tax advantage is priced in.

The third is price. Aim portfolio managers would like you to understand that choosing smaller BPR-compliant stocks that are not particularly well covered by analysts is jolly hard work and that you will need to pay up for that work. This is one of the few areas of the industry where you will still find yourself paying an initial charge and a high annual management charge (think 2% per year plus).

All said, it really is not that awful an idea. If you have enough other assets that your Isa assets are likely to attract IHT at 40%, it's going to take a good few years for the charges to eat up the savings.

The same goes for performance. Aim shares might be more risky than those on the main stock exchange (or might not be in this environment this is up for debate). Even so, your portfolio would still have to fall an awful lot more than a large-cap alternative for you (or to be precise, your heirs) to suffer a relative loss after taking the tax savings into account.

Do nothing and your heirs will definitely lose 40% of the cash. Do this, and there is a perfectly reasonable chance they'll get to pocket most of it.

So where do you go to find your mildly overpriced tax-avoiding product? Alex Davies of Wealth Club suggests the Octopus Aim Isa (initial fee 0.75%, annual fee 2%) and the Unicorn Aim Isa (1% and 2% respectively). The former is, he says, the oldest and one of the best performers in the sector (up 27% last year).

Unicorn has a manager with a good reputation, but like most other funds in the sector it doesn't have a very long performance record. On the plus side that doesn't matter as much for this as it does with most of the investments I write about. After all, you aren't in it just for the performance.

This article was first published in the Financial Times