Secrets of the ISA: Part 1

Despite its numerous benefits and advantages the Individual Savings Account (ISA) does also come with a number of nuances that may be lesser known or simply a bit more obscure.


Most people will already be aware that the annual limit that you can put into an ISA is £20,000 (2020/21) and that any interest, gains or growth within the ISA will remain tax free regardless of the amount. It's a bit like a personalised tax haven within the UK itself, but there are a number of rules that you must follow and if you break those rules things become a little... unfamiliar.


Here are some proposed questions:

  1. Can I open more than one ISA account in a single year?

  2. Can I withdraw money from my ISA and then re-deposit it without using more allowance?

  3. Is it possible to increase my ISA by more than £20,000 each year?

The answer to all three of these questions is "yes", but there will be certain conditions and rules that must be met in order for it to be possible.


I had these questions myself once upon a time and the information is out there in various sources, including the .gov.uk website; but it's all scattered and kind of hard to string together. But I think I gave it a pretty decent attempt and I want to share that here so you have an easier time consuming it all.


The basics of an ISA and the different types


Just in case there are any personal finance newbies here let's start off with briefly covering some of the fundamentals so we're not leaving anyone behind later on.


As already mentioned an ISA is a tax sheltered account that you can open in order to place a portion of your money into each year to ensure that any further gains or growth on that money is fully kept by yourself. However, there is a limit on how much you can place into the ISA known as your annual allowance.


Right now (2020/21) the annual allowance is fairly generous at £20,000, but this hasn't always been the same and may increase or decrease in the future depending on the UK government's financial policies.


For reference, the current annual allowance came into effect in the tax year of 2017/18. Before that the limit was £15,240, and was even lower the further back in time you go. One good thing to note is that since its inception in 1999 there has never been a decrease in the ISA annual allowance, but you can never know what might happen in the future.


Contributions into an ISA are always made after tax has been paid on your income, meaning there is no salary sacrifice scheme like there is with the pension. There also isn’t a government top up that gets added to your own contribution for most types of ISAs (we'll cover the exception later).


There are currently four different types of ISA for adults and two types of ISA for people under the age of 18:


A table of the different types of Individual Savings Accounts, what they're used for and their annual allowance limits

Within a single tax year you are only able to open and pay into one of each type of ISA. For example if you open a Cash ISA this year you cannot open or deposit money into another Cash ISA until next year. However, if you wanted to open a Stocks & Shares ISA you could do so, even though you had opened a Cash ISA already; this is assuming you haven't already opened a Stocks & Shares ISA this year.


The annual limit on each ISA type is the maximum amount you can deposit into that account each year. For the most part this is the same as your annual allowance of £20,000 if you're an adult, or £9,000 if you're a junior person, but there does exist an exception in the Lifetime ISA.


You can choose to utilise all of your annual allowance by putting your money into a single type of ISA or you could spread your deposits between different ISA types depending on your strategy. All this really means is that you will not be able to take all of the different ISA types up to their annual limits within a single year. We'll work through a few examples to clarify this later in the article.


Here's a table of the different ISA types and the key points about each:


A table of different types of Individual Savings Accounts, they key points and rules and any age limitations

Junior ISAs, especially the Junior Stocks & Shares ISA, are a great way to get your child started early on their own journey towards financial independence. With such a long timeframe ahead of them they'll easily be able to reap the benefits of compounding returns which will result in something quite phenomenal by the time they reach their own retirement age. Don't we all just wish we could have an extra 18 years being in the market?


The amounts being deposited into the Junior Stocks & Shares ISA don't even need to be huge despite the annual allowance being £9,000 each year. Just investing £185 each month into a global index tracker would be enough to make them into a millionaire by the time they reach the age of 50, assuming an average annual return of 7% each year.


But don't forget to teach them the key principles that will enable them to understand how achieving that amount of wealth was possible, and how to maintain it into their own future. The last thing you want is to build up a great fund for your child, only for them to squander it away!


Alright, now that we've got the basics out of the way I think it's time to move onto some of the nuances.


The different situations and rules can sometimes be a bit convoluted and therefore difficult to understand, and if you're not careful you might accidentally lose the ISA status on some of your savings or even miss out on some of your allowance without realising it. The purpose of going into these nuances is to help you understand and be aware of the finer details so that you are able to make more deliberate and effective decisions with your money.


Moving ISA providers


In order to entice you some ISA providers may provide a preferable interest rate or even signup bonuses if you open a Cash ISA with them. Sometimes this offer might actually be the best that's available to you at the time but after the honeymoon period (usually after about a year) you might find that the interest rate you get isn't that great compared to some other new offers out there.


You might even see the very same ISA provider you are with offer a better interest rate to new customers; but since you're old news you don't get that option (the cheek!).


In times such as these you might want to consider going with a new ISA provider, if they have a better offer for you, by opening a new ISA with them and then depositing "new money" (money that isn't already in an ISA) into that new account to get the preferred interest rates.


When it comes to a Stocks & Shares ISA you might find an ISA provider that offers cheaper platform fees or better transaction fees, meaning you're losing less of your money to costs. High costs make a massive difference when it comes to the overall returns you get from your investments as I've already covered in a previous article, so it's definitely worth considering the new ISA provider even if the savings on costs seem small as it will add up over time.


Again when eligible, you can opt to go with the new ISA provider by opening up a new Stocks & Shares ISA and then using that account going forward to invest your money.


One really important thing to remember whenever you find a new ISA provider that has a better offer for you at the time is:


Don't close your existing or old ISA even if you don't plan to deposit any more money into it!


This is because if you close the ISA all of the money within that account will lose its tax sheltered status and you will not get back any of your annual allowance that you used up in previous years.


Now here's a bit of a dilemma; with your shopping around for better ISA deals you might end up with a number of different accounts with different ISA providers after a few years. This is fine as there's nothing wrong with having a number of ISAs with different providers but if you like to have things neatly consolidated in one manageable place you might consider moving your money all into one account.


Don't withdraw your money from your old ISA to put it into the new ISA!


Doing this will also cause your money to lose its ISA status when withdrawing and will use up your annual allowance when depositing into your new ISA. Instead you will want to perform an ISA Transfer which can be arranged via the new ISA provider you are planning to go with.


By performing an ISA transfer you ensure that your money never leaves its tax shelter and that you can keep any unused annual allowance for your money that wasn't already in an ISA. Here are a few things that are useful to be aware of when doing an ISA transfer:


  1. Some ISAs may have penalties if you withdraw or transfer your money away early, so always check the fine print.

  2. Transferring an ISA will involve an ISA transfer form that you receive from the ISA provider that you want to move to. They will do the actual transfer for you.

  3. You can transfer between different ISA types i.e. Cash ISA to Stocks & Shares ISA.

  4. A transfer doesn't necessarily need to be to a new ISA provider. You might be transferring to a different ISA type with the same ISA provider for example.

  5. Some investments in an Innovative Finance ISA may not be transferable, but you should be able to transfer any cash that is held in the account.

  6. A withdrawal fee will be applicable if you transfer a Lifetime ISA to a different type of ISA before the age of 60.

  7. Typically a transfer between Cash ISAs shouldn't take longer than 15 working days, and it shouldn't take longer than 30 calendar days for other types of transfer.

  8. During this time your money may not be in either of your accounts but don't worry, this is normal.

  9. Money placed into an ISA in the current year must be transferred in full. Money placed into an ISA in previous years can be partly transferred or transferred in full.

  10. There isn't a limit on the number of ISA transfers you can make in a single year.


There's never any rush when transferring an ISA so it really does pay off to take the time to understand some of the finer details. Don't be intimidated though as you can always get in touch with your new ISA provider; I'm certain they'd be more than accommodating in helping you through the process.


As a final note for this section, there can be benefits to having multiple ISAs with different ISA providers. One example is the extra protection on your money through the Financial Services Compensation Scheme (FCSC). If one of your ISA providers goes bust then up to £85,000 of your money should be compensated, but if you had more money in the account then the excess could be lost forever.


However, if you had your money split between different providers and had less than £85,000 in each account then your money might be fully covered by the scheme.


Note: The different providers would need to be different financial institutions. It is possible that different ISA providers might be part of the same financial institution which means your money may not be as well covered as you thought. This'll be a good article for the future!


Verdict: Picking new ISA providers based on better offers that come onto the market is a perfectly normal thing and encouraged if you want to make the most of your hard earned money. But there is a process to follow if you don't want accidentally lose the tax sheltered status on your money. Work with your new ISA providers when making a transfer to ensure a smooth and easy process as they will be familiar with what needs to happen.


Multiple ISAs in the same year: what's permitted and what's not


I mentioned earlier in the article that it is only possible to open and pay into one of each type of ISA within a single year. Additionally, there are also some circumstances where you can't open an ISA of a particular type even if you haven't "opened a new account" of that type of ISA in the current year.


To help illustrate these different scenarios let's work through the following examples:

  1. Trying to open two accounts of the same ISA type in a single year.

  2. Contributing to an ISA and then trying to open another account of the same ISA type in the same year.

  3. Trying to open an ISA of a type that you haven't used yet, after you have already reached the limit of your annual allowance.


Trying to open two accounts of the same ISA type in a single year


A table showing what happens if you try to open two ISA accounts of the same type in the same year

Vanguard and Hargreaves Lansdown are both different ISA providers.


In the above example you cannot open a Cash ISA with Hargreaves Lansdown because you have already opened one with Vanguard in the current tax year. You will need to wait until next year before you are eligible to open a Cash ISA with Hargreaves Lansdown.


However, you can continue to deposit money into your Vanguard Cash ISA in the current year up until the annual allowance limit of £20,000.


If you tried to open a second Cash ISA account with Vanguard the rule would still apply, but the most likely thing that would happen is that Vanguard will simply tell you to just use the account that you have already opened.


Contributing to an ISA type and then trying to open another account of that same ISA type


A table showing what happens if you try to open two ISAs of the same type in a single year

In this example you already held a Stocks & Shares ISA with Vanguard from 2019/20, meaning you didn't "open" it this year. You are still able to deposit money into it during the current year of 2020/21, and you do so by depositing £5,000 for example.


By doing this it effectively commits you to that Stocks & Shares ISA for the current year, and it is treated the same as opening an account of that ISA type. Therefore when you try to open another Stocks & Shares ISA with Hargreaves Lansdown you would not be allowed.


This also applies in reverse; if you first opened a Stocks & Shares ISA with Hargreaves Lansdown in 2020/21 it would mean that you would not be allowed to make that deposit of £5,000 into your existing Vanguard account from 2019/20.


However, there's nothing stopping you from keeping previous Stocks & Shares ISAs and managing them. As long as you don't deposit any more cash into those accounts you are free to buy and sell your investments within the ISA itself.


Opening an ISA type you don't have, after you've reached your annual allowance


A table showing what happens if you try to open an ISA after you have already reached the annual allowance

In this example you have contributed a total of £20,000 into three different ISA accounts successfully. The types of accounts you have utilised for the year are the Stocks & Shares ISA, Cash ISA and the Lifetime ISA.


Even though you haven’t opened or contributed into an Innovative Finance ISA account for the year you will not be able to open one, even if you found a provider that allows opening an account with no deposits.


This is because you have reached your annual allowance and you will need to wait for your allowance amount to be reset in the following year.


Verdict: Opening multiple ISAs in the same year is possible but only if they are different types. However, depending on your actions you might not be able to open any new ISAs if you continue to contribute to existing account that you already hold from previous years.


You can actually increase an ISA by more than £20,000 in a year


It's common knowledge that the annual allowance is £20,000 for an adult ISA and £9,000 for a child ISA. Despite this, there are actually certain circumstances that allow you to go over the limit for the year. These scenarios are quite specific but can be utilised without any concern of breaking the rules; in fact it is the rules themselves that have enabled this to be possible.


There are four possible scenarios that I want to cover to explain how the limits work:

  1. The standard £20,000 allowance.

  2. Using the government top up to reach £21,000.

  3. Using the eligible age overlap to reach £29,000.

  4. Using the flexible allowance to increase by almost any amount.


The standard £20,000 annual allowance


A table showing the ISA annual allowance of £20,000 being reached

This is the most common and straightforward scenario as it simply uses adult ISA types. The annual allowance is utilised across the three different account types opened first: £10,000 into a Cash ISA, £6,000 into a Stocks & Shares ISA and £4,000 into an Innovative Finance ISA.


As these are all different types of ISAs you are allowed to open and deposit money into them within the same tax year. However, the final action of trying to open a Lifetime ISA is not permitted as you have already reached the annual allowance limit.


As none of the accounts that you successfully deposited money into give an additional top up the final total amount that you have increased your ISA by is £20,000. This doesn't include anything earned through interest, capital gains or dividends.


Using the government top up to reach £21,000


A table showing how the an ISA can be increased by an extra £1,000 above the £20,000 annual allowance

By utilising the Lifetime ISA you are able to go over the ISA annual allowance by up to £1,000 depending on how much you contributed into the Lifetime ISA. This is because the government tops up any amount you deposit into a Lifetime ISA by 25% up to a maximum of £1,000 each year, and that top up doesn't use any of your annual allowance.


Your £20,000 plus the government's £1,000 comes to a total of £21,000 in a single year.


The best thing about the top up is that you're also able to invest it, meaning it can grow in the long term into something quite substantial. Quite tempting considering you're receiving that money for free.


But don't forget that the money in your Lifetime ISA cannot be withdrawn before you are 60 (without penalties) unless you are using it to buy your first property. It's not a bad thing, but very important to keep in mind.


Using the eligible age overlap to reach £29,000


A table showing how a child at the age of 16 or 17 can deposit a total of £29,000 into their ISAs by utilising both child and adult annual allowances

This scenario is very specific and can only be done by a child aged 16 or 17 (or their parent or legal guardian) who utilises both Junior ISAs and Adult ISAs. With the minimum age to open an Adult Cash ISA being 16 and the maximum age to have Junior ISA being 18, there is a moment in time where a child at the age of 16 or 17 can hold both at the same time.


This makes them eligible for both the junior annual allowance of £9,000 and the adult annual allowance of £20,000 at the same time, and by contributing into a Junior ISA it doesn’t reduce the amount that can still be contributed into an Adult ISA or vice versa.


As there is no restriction between junior and adult accounts the parent, legal guardian or child themselves can contribute £5,000 into a Junior Cash ISA and £4,000 into a Junior Stocks & Shares ISA as an example. This maximises the amount that can be contributed into the Junior ISA. From this point, a further £20,000 can be contributed into a Adult Cash ISA which brings the total amount up to £29,000 for the year.


Note: The amounts contributed to the Junior ISA types are examples, you could do £4,500 into the Junior Cash ISA and another £4,500 into the Junior Stocks & Shares ISA, or any other arrangement as long as it doesn't go over £9,000 in total for the year.


The Adult Cash ISA is the only type of adult ISA account where this is possible as the other types have a minimum age requirement of 18 years old.


This loophole appears to be known by HMRC and has been around for at least a few years, with no signs of it being considered foul play by the government. However, you never know when things might change so it is best to utilise this advantage if possible and while it is still available in order to give your child the best head start in their journey towards financial independence.


Using the flexible allowance to increase by almost any amount


It is difficult to put a number on this scenario because the amount you can deposit could be increased by almost any amount.


This is done by using what's known as a Flexible ISA where you are actually allowed to withdraw money out of the ISA and re-deposit it within a certain time window without any allowance penalties. The amount is only limited by the amount you have within your Flexible ISAs which could vary from person to person.


It takes a few more examples to explain so I'll dive into the detail in the next section of the article.


Verdict: Despite there being a standard annual allowance of £20,000 there are certain scenarios in which you are able to get more money into your ISA in the same year. These scenarios are quite specific and might not always be available to everyone, but it is handy to be aware so that you aren't missing out if one of those scenarios suddenly apply to you.


What are Flexible ISAs and how do they work


When it comes to withdrawing your money from your ISA it is important to remember that in most cases this means it will lose its tax shelter status. If you deposit that money back into an ISA it will regain its tax shelter status but you will use up some of your annual allowance, meaning that you double dipped.


Fortunately you can get a grace period by making use of a Flexible ISA, which allows you to take money out and put it back in without it losing its tax shelter status or consuming more of your allowance. The caveat to this is that the money must be returned into the ISA within the same tax year otherwise the grace period is lost.


Let's cover the following scenarios:

  1. Withdrawing and re-depositing in a Non-Flexible ISA

  2. Withdrawing and re-depositing in a Flexible ISA in the same tax year

  3. Withdrawing and re-depositing in a Flexible ISA in different tax years


Withdrawing and re-depositing in a Non-Flexible ISA


A table showing what happens to your annual allowance if you withdraw money from a non-flexible ISA account and then deposit money into it within the same tax year.

In this example you have opened a Non-Flexible ISA and you start by depositing £10,000 into it.


However, part way through the year you might need to make a withdrawal from that account for an emergency reason. Perhaps your emergency fund wasn’t completely prepared for a financial emergency and therefore you needed to take out £5,000 from your ISA to help deal with it.


The action of withdrawing from your ISA doesn’t reduce your remaining allowance for the year but it does reduce the amount of your money that is sheltered from tax. You now only have £5,000 remaining in your ISA, with the other £5,000 that you withdrew being exposed to tax.


You deal with your financial emergency and work hard to save up some more money. Just before the tax year finishes you make a deposit into your ISA to utilise the remainder of your annual allowance, which is £10,000.


At the end of the year your ISA balance is £15,000 despite making a total of £20,000 in deposits. This is because you took out £5,000 partway through the year which cannot be deposited back into the ISA as you don't have enough annual allowance remaining. You need to wait until next year when your annual allowance tops up again.


Withdrawing and re-depositing in a Flexible ISA in the same tax year


A table showing how you can withdraw and re-deposit money into a Flexible ISA as long as you do so within the same tax year

In this example you have a Flexible ISA that you have been depositing money into for a number of years. Between the tax years of 2017/18 and 2019/20 you deposit the maximum annual limit, meaning you managed to build your account up to £60,000 over 3 years.


In 2020/21 you decide to invest into a property and you need to take money out of your ISA to afford it. You withdraw £50,000 and this leaves you with £10,000 in your ISA that is still sheltered from tax. However, that £50,000 you withdrew may not have permanently lost its ISA status just yet even though at this moment in time it is exposed to tax.


As you have a Flexible ISA you have a grace period in which you can put that £50,000 back in without it using up your current year’s annual allowance of £20,000, which you still have available to you. This effectively means you can deposit a maximum of £70,000 in the current tax year as you haven’t made any other ISA deposits so far.


You do some improvement work on your investment property and manage to sell it later in the year, still in 2020/21. The profit is £15,000 on top of your £50,000.


When the tax year is almost over you decide to quickly put your money back into your Flexible ISA before the grace period is over. You also decide to put in your profits meaning you deposit a total of £65,000. Since you were allowed to put up to £70,000 for the year this actually means you still have £5,000 remaining in annual allowance.


Ideally you can use this up before the year is over but in this example we will leave it on the table.


Effectively you have deposited much more than the annual allowance of £20,000 in a single year but that extra allowance comes from your Flexible ISA which you withdrew money from in the first place.


Note: The profit made from the property investment will be liable for Capital Gains Tax as you needed to take the money out of an ISA first, and the profit is above the £12,300 tax-free threshold. But still, gaining an extra £15,000 pre-tax to deposit into your ISA is not a bad effort at all.


Withdrawing and re-depositing in a Flexible ISA in different tax years


A table showing how the cash withdrawn from a Flexible ISA will permanently lose its ISA status if the tax year ends before it is re-deposited into the Flexible ISA

In this example you have the same amount of money in your ISA going into 2020/21 as the previous example, £60,000. You also make the same withdrawal of £50,000 to invest into a property.


However, in this example it takes longer for you to sell your investment property and therefore you do not have the cash available until the next tax year of 2021/22. This means you lose your flexible allowance of £50,000 plus the original annual allowance of £20,000 for 2020/21 since you contributed nothing in that year.


In 2021/22 you can only make a maximum deposit of £20,000 which is the annual allowance you are entitled to for the year.


Obviously this isn't as good as the previous example where you were able to get your money and profits back into the ISA, but making a sizeable profit on the money you withdrew is nothing to sniff at. At least you have other allowances besides the ISA available to you (as mentioned in a different article) to help keep your tax bill down while you work that money back into an ISA over the next few years.


Verdict: Ultimately, whenever you are withdrawing money from your ISA you should be wary that you may be losing out on its tax-shelter status unless the ISA is flexible. Even if the ISA is flexible you still need to work within a certain time limit in order to utilise that flexible allowance. Not all ISAs are flexible so always check with your ISA provider to make sure that this is the case before withdrawing money, because once the allowance is gone there is no way to get it back.


There's more to come


Phew! That was a lot of handle and we're only at the end of part 1.


The ISA is an exceptionally powerful tool for people to utilise in their journey towards financial independence and the basics can essentially be boiled down to the following: £20,000 a year that you can shelter from tax and make tax-free earnings forever, amazing!


But by looking through some of the scenarios and examples covered in this article it is understandable why some people out there might find various aspects of the ISA confusing. Sometimes it's easy to forget that the things that are "simple" to us may not be the case for others, and hopefully with the details covered in this article it has made the ISA an easier thing to understand for everyone out there.


In part 2 that will be published next week I will cover the following:

  1. Can you transfer investments into a Stocks & Shares ISA?

  2. What happens if you go over the annual allowance?

  3. What happens if you double down on an ISA type?

  4. Can you inherit an ISA tax free?

  5. What happens to your ISA after moving abroad?

  6. Child Trust Funds: Should you transfer them into a Junior ISA?


So be sure to check back!


Update: Read Part 2 here.



References

Throughout this article I mentioned various concepts and principles that I have covered in previous articles. If you want to get into the details of those you can find the links below:

  1. How hard is it to save £1 million

  2. Why does every recommend passive index funds and to avoid timing the market?

  3. Does a Stocks & Shares ISA really matter when it comes to tax

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For me, the purpose of financial independence is to regain control of my personal time rather than needing to spend it in work. Money is just a means to get there and not the end goal itself. In writing this blog I hope to use my own experiences to help others find their reason on why they want to reach FIRE.

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Kujah

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