ISA tax benefits
If you are looking for a way to protect your savings and investments from tax, an ISA is an option with several important tax benefits. For example, any investment gains, interest, and UK dividends you make are tax-free.
Each tax year, you have an annual allowance of £20,000 to contribute to your ISAs to help you take advantage of the following ISA tax benefits.
You do not pay tax on dividends in a Stocks and Shares ISA
A key Stocks and Shares ISA tax benefit is tax-free UK dividends. In contrast, you may have to pay tax on dividends earned in a general investment account.
You have a £2,000 tax-free dividend allowance each tax year. Any dividend income you earn over the £2,000 allowance is taxed. The rate of tax depends on your Income Tax bracket: 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers.
The UK dividends you earn in a Stocks and Shares ISA do not count towards your tax-free dividend allowance and are tax-free.
ISAs are not subject to Capital Gains Tax
Similarly, any profits you earn from your investments in a Stocks and Shares ISA are tax-free.
Unlike general investment accounts, your investments in an ISA are exempt from Capital Gains Tax.
If you make a profit on your investments in a general investment account, you may have to pay Capital Gains Tax when you sell them.
Each tax year, you have a tax-free Capital Gains Tax allowance of £12,300. Profit you make from other assets, such as from property which is not your main home, also count towards this allowance.
Any profit you make over the threshold is taxed and the rate depends on your tax bracket. If you are a basic rate taxpayer, you will pay 10% tax. If you are a higher rate taxpayer, you will pay 20% tax.
You never pay tax on interest with an ISA
Any interest you earn in an ISA is also tax-free.
This is an advantage for Cash ISAs as you are guaranteed not to pay tax on the interest that you earn on your savings.
It may also apply to Stocks and Shares ISAs, as some investments generate interest. For example, most bonds pay a fixed rate of interest twice a year.
Whether your interest is from savings or investments in an ISA, it will be tax-free. Therefore, it will not count towards your tax-free Personal Savings Allowance for income from interest. Your Personal Savings Allowance depends on your Income Tax band: £1,000 for basic rate taxpayers, £500 for higher rate taxpayers and £0 for additional rate taxpayers.
It is possible to pass an ISA on to a spouse or civil partner without paying Inheritance Tax
Your spouse or civil partner can inherit your ISA tax-free after your death.
If you don’t have a spouse or civil partner to pass your ISA onto, you can choose a beneficiary for your ISA. However, it will become part of your estate and will be subject to Inheritance Tax.
If your total estate is lower £325,000, then your beneficiaries will not have to pay any Inheritance Tax and your ISA will be passed on tax-free.
Any part of your estate which is over the £325,000 threshold is taxed at 40%, although there are further allowances for your main residence.
Your ISA will not form part of your estate or be charged Inheritance Tax if it is inherited by your spouse or civil partner.
There is no tax when making withdrawals from an ISA
Whenever you withdraw money from an ISA, it is tax-free.
The only exemption is Lifetime ISAs which have a 25% withdrawal penalty unless you take the money to buy your first home or after you turn 60, as a form of retirement income.
The ability to take money out of an ISA tax-free contrasts with income from pensions, which is taxable at your rate of income tax. However, with a pension your contributions are made free of tax. ISA contributions do not benefit from tax relief – they are paid from post-tax income.
You can also withdraw money from most ISAs whenever you choose to, whereas pensions are only accessible from age 55 (rising to 57 from 2028).
You do not have to declare an ISA on your tax return
No matter how big your ISA grows to be, you will not have to declare it on your annual self-assessment tax return.
Additional tax benefits of ISAs
ISAs can reduce the impact of the High-Income Child Benefit Charge
If one parent in a household is earning £50,000 or more, the High-Income Child Benefit Charge is triggered. This charge effectively reduces the amount of child benefit you receive by 1% for every £100 over £50,000 you earn, because you have to pay back that amount in the form of a tax charge. If you earn over £60,000 you would have to pay back all child benefit received through a tax charge.
Your income is calculated as ‘net adjusted income’ which includes income from savings and investments as well as salary and bonuses. Therefore, having your savings or investments in an ISA will ensure that the returns you make do not count towards your ‘net adjusted income’. That could help you to avoid triggering the High-Income Child Benefit Charge.
For example, if you earned £50,000 from salary and bonuses and £1,000 in interest and investment income, your net adjusted income would be £51,000. This would put you £1,000 over the threshold and reduce your child benefit by 10%.
If you earned that £1,000 in interest and dividend income in ISAs, then it would not count towards your net adjusted income and the High-Income Child Benefit Charge would not be triggered.
ISAs can help preserve a higher earner’s personal allowance
Similarly, income earned within an ISA does not count towards your income for the personal allowance means test.
Your £12,500 tax-free personal allowance is reduced by £1 for every £2 over £100,000 you earn. If you earn £125,000 or more, you will have no tax-free personal allowance.
For example, if you earned £100,000 in a tax year and earned £5,000 in dividend income that year, your ‘net adjusted income’ would be £105,000. Your tax-free personal allowance would be reduced by £2,500, and you would have to pay Income Tax on an extra £2,500 of your earnings.
If you earned that £5,000 dividend income in an ISA, it would not count towards your net adjusted income. You would keep your full £12,500 tax-free personal allowance.
Learn more about our Stocks and Shares ISA
Learn how to make the most of your Stocks and Shares ISA with our useful guides.