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Another good reason to open an ISA

The paperwork for capital gains tax can seem never-ending.

There are savers and investors out there who do not religiously open an ISA (or top up an existing ISA) every year in order to use up as much of their annual ISA allowance as they can.

This is nuts.

ISAs are one of the best tax breaks going for the likes of you and me.

Everything you hold in an ISA is shielded from capital gains tax.

There’s no tax to pay on interest or on the dividend income from shares held in an ISA, either.1

Tax might not seem a big deal when you’re starting out with investing. But over the long-term, paying too much tax can dramatically cut your returns.

It’s true that there can be modest fees for holding an ISA on some platforms. But it doesn’t take much for the tax breaks to outweigh these tiny costs – maybe as little as £100 or so in dividend income if you’re a higher rate tax payer.

Even these platform fees can be avoided if you simply open an ISA directly with a fund provider and invest in, for example, one of their cheap tracker funds.

But there’s another good reason to get into the habit of investing in ISAs.

Whatever you buy in an ISA and whatever gains you make from your investment – capital gains or income – is your business. You don’t have to tell HMRC about it and it doesn’t want to know.

Using ISAs for all your investments therefore sidesteps the horrors of paperwork that can build up if you invest outside of their lovely HMRC-shielded protection

Avoiding self-assessment paperwork with an ISA

I can think of plenty of places I’d rather not be at two o’clock in the morning.

Delivering pizzas in Kabul, Afghanistan, for example.

But being in my home office filing through old share trade notes to calculate my CGT situation for the taxman – that’s right up there with the war zones.

You have to declare details of your capital gains and losses from share trading over the past financial year if:

  • You made more than your CGT allowance in capital gains in the year
  • You made total disposals of 4x that allowance

And you might be surprised to discover how easy it is to stumble into such a situation…

Let me take you back to 2009.

I sold quite a few holdings in the tax year to 5th April 2009, recycling the proceeds into what I guessed judged were safer harbors during the bear market.

As you’d expect back then, this meant I realised capital losses. Even if I wasn’t bound by law to detail them to HMRC, I’d have done so anyway to carry the losses forward to set against CGT in future years.

But as it happened I did have to detail them, because my total disposals were beyond the 4x threshold.

For example, I sold my remaining bank shares in summer 2008, which looking at the prices I got for them seems a lot cleverer/luckier in retrospect than it felt at the time.

Selling Lloyds shares for between £2 and £3 when I got cold feet about the merger with HBOS was hard, given they’d recently been over £6. But considering the share price approached 30p within 6 months, I thank whatever angel was sat on my shoulder that day.

Looking at other trades was equally painful; positions built up over years sold at less than cost, down from twice that level in 2007.

And I had to note it all down for the taxman. Talk about adding insult to injury!

(Note that I typically didn’t take the money raised out of the market. Selling low and missing the upturn is a classic bear market error; instead, the money my sales realised were recycled into other shares, trackers, and trusts. I was a net buyer during the bear market).

In short, share trading outside of an ISA was a lot of hassle and paperwork for a pretty uncertain return that year.

(Remember, it’s better to use a tracker folks!)

There’s hassle, and then there’s Sharebuilder

What made this tax accounting exercise even more tedious was that most of the shares I sold were located in a so-called Sharebuilder account where I had held my high-yield portfolio.

Sharebuilder accounts seem a great idea, because they enable you to buy small bundles of shares at a much lower cost per trade (£1.50 a trade back then, since raised to £2).

You can even set them to automatically re-invest dividends, which at the time I was doing it incurred no commission fees at all.

The trouble comes when you have to calculate a taxable gain or loss on disposal. Then the Sharebuilder is an instrument of torture.

I had some positions built up from half a dozen more purchases or more over the years, including reinvested dividends.

This meant I had to tediously go through and collect all the transactions to calculate my total purchase costs.

With Sharebuilder, I also frequently ended up buying fractions of shares. This seems a lot less cool at two in the morning when you’re staring at something like:

BT.A
23-Jan-04  BUY    269.3072    184.18
5-Mar-04   BUY    274.524021  180.68
20-Aug-04  BUY    136.464485  181.19
7-Sep-04   BUY    15.566294   184.18
14-Nov-04  BUY    249.38911   198.89
29-Nov-04  BUY    253.557919  195.62
8-Feb-05   BUY    22.261045   208.93
27-Oct-05  BUY    219.669073  203.67

Believe it or not, it got even worse.

The ultimate nightmare is when some shares were bought and sold multiple times over say a five-year period.

Back in those days, the rules said you had to work out how a pool of expenditure on the shares changed over time, in order to work out the capital gains or losses due. (Thankfully this element of CGT accounting has since been simplified).

In short, paperwork like this is fiddly and boring, and if you’re lucky you’ll never have to do it. (If you’re unlucky and you’re stuck, check out the UK government page on tax arising from share transactions for more details.)

I spent a weekend digging through old trades and working out my gains and losses on disposal that year.

What idiot said share trading was fun?

ISAs and SIPPs avoid all this hassle

Avoiding tax on gains and dividends is the big benefit of ISAs and SIPPs.

But being free of this paperwork is another great reason for using a tax-exempt trading account to hold your shares.

ISAs and SIPPs (Self-Invested Personal Pensions) enable you to shelter your holdings free from income and capital gains tax – and also from paperwork.

The tax advantages are obviously worth having. But the thing is, many people will take a few years to reach the stage where their investment will be generating serious dividend income. Or else they’ll invest in a tracker or other fund and allow it to grow without selling it.

They therefore wonder why they should bother setting up an ISA, especially if they have to pay a fee for it, since they’re not getting much income or seeing capital gains in the early days.

But eventually through regular saving and reinvesting, dividend income will grow to be meaningful. When it does you’ll curse the unnecessary tax you’ll pay on your hard-earned investments.

Equally, deferring capital gains by not selling is a fine strategy – right up until you do need to sell2, and then you discover you owe the taxman a big slug for two decades worth of growth.

Yet even if these tax benefits take a while to show, avoiding paperwork is a bonus you get straight away when you open an ISA or a SIPP for share trading.

You aren’t expected to tell the taxman what you hold in an ISA. He doesn’t want to know. You can make gains and losses in your own perfect little ISA kingdom, free of the toll of the taxman.

I have about half my portfolio in ISAs and a little more in a SIPP. I started using tax shelters too late, and so will forever be playing catch up by moving my money into them (likely by harvesting capital gains on unsheltered holdings).

I see little chance of me ever sheltering all my money within them, unless I stop earning and saving altogether.

But just maybe you can do things differently.

If you have only recently started investing, you can avoid this sorry fate by thinking about tax shelters from day one.

Or if you’re an old hand who is yet to open an ISA – yes, they exist, I’ve met a few – then bite the bullet and start sheltering your funds from tax today.

Remember the deadline for opening an ISA is April 5th.

Note: This article on reasons to open an ISA was updated in 2015 to reflect the current tax situation.

  1. I don’t want to hear a peep in the comments about the hoary old 10% dividend credit you used to get a trillion years ago in an ISA but don’t any more. The old situation is irrelevant and anyway in almost all situations the 10% ‘tax’ is not a tax you pay as such. []
  2. It’s not always your choice – companies get taken over for cash surprisingly often, for instance. []

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{ 54 comments… add one }
  • 51 The Investor March 18, 2015, 9:42 pm

    p.s. I don’t quite understand/agree with your maths, or at least the way you’ve stated it, unless I’m having a moment of brain failure. 😉

    It doesn’t deliver almost “6% interest growth” does it?

    It is the *equivalent* of earning interest on cash savings at 6%, and then paying higher rate tax on it to bring you down to 3.49%.

    i.e. You’re still only ‘earning’ at 3.49%, not near-6%?

  • 52 Tim March 19, 2015, 12:38 am

    Yes you’re right, sorry I should have been clearer, 6% is in comparison to a non-isa saving product.
    Related question; would we not be better off putting that money in a pension (assuming we don’t need access to it) before we consider filling up our Isa -£50k Max per annum. There I’d immediately get a 40%+ benefit. So even if the market crashes say 30% I’m still better off than putting it in a stocks and shares ISA where the tax man takes his cut first.

  • 53 The Investor March 19, 2015, 12:52 am

    @Tim — See these articles. (The search bar top right is your friend! 🙂 )

    http://monevator.com/pensions-versus-isas/

    http://monevator.com/sipps-vs-isas-best-pension-vehicle/

  • 54 Jeremy August 29, 2015, 5:18 pm

    I appreciate the horrors of a CGT return and avoiding one probably trumps any benefits I’m about to query. But from 2016 with a dividend tax allowance of £5000 and an interest allowance of £500 (for higher rate payers) it seems, relatively speaking, to increase the attractiveness of putting the £15k ISA share of that money into a Cash ISA rather than a Shares ISA? (and acquiring similar amount of a fund outside an ISA, rather than the other way around?)

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