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Most tax efficient investments in ISAs?

 Financial Advice | General Helpful? 12

Asked by Redwinebox20499, submitted 29 December 2012.

Open Quote Since Corporation Tax is deducted from dividends paid by UK companies is it a good move to have Equity Income Funds invested in ISA's or would it make more sense to have only growth funds within the ISA wrapper and leave Equity Income investments outside of the ISA?End Quote

Answered by Justin on 04 January 2013

From a tax point of view you're actually better off holding interest paying investments, such as corporate bonds within ISAs. A brief overview as follows:

As you mention, dividends are paid out of company profits on which corporation tax is paid. They're effectively deemed to be paid net of basic rate tax, although this cannot be reclaimed by non-taxpayers, nor within an ISA/pension. Basic rate taxpayers have no further tax to pay while higher rate taxpayers owe an extra 25% of the dividend received (based on current tax rates). So basic rate taxpayers will not save any income tax by receiving dividends within an ISA, but higher rate taxpayers will save 25%.

As for gains, they're tax-free within an ISA. Outside of an ISA you can offset realised gains (i.e. actual gains from selling, not paper gains) against your annual capital gains tax allowance, currently £10,600. So this may not be an issue, depending on the level of gains you anticipate outside of ISAs.

Interest received within ISAs is tax-free. This means basic rate taxpayers save 20% income tax and higher rate taxpayers 40% on income from the likes of gilts and corporate bonds held within ISAs.

Of course, no point holding interest paying investments within ISAs to save tax if you wouldn't otherwise buy them. But if you do have some then these should generally take precedence in your ISA unless you regularly exceed your annual capital gains tax allowance.

Whether equity income or growth investments should be preferred within ISAs depends on your tax position. For example, basic rate taxpayers who don't regularly use their capital gains tax allowance won't save tax from holding either in an ISA, whereas a higher rate taxpayer would at least avoid paying extra income tax on dividends.

But I think the bottom line is invest in what you believe in,. then look at tax as a secondary consideration. And provided you're not paying for an ISA wrapper then use one anyway, even if you won't save tax at first - it makes admin simpler and might save tax in future if your situation changes.

Please note this answer does not constitute a recommendation or financial advice and should not be relied upon when making specific investment or other financial decisions. You should always undertake your own research into whether a product or service is appropriate for your needs and, if necessary, use a qualified professional adviser.

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Readers' Comments (4) - To post a comment please register or login .

Comment by BernieB at 5:30pm on 23 Jan 2013:

A small point. A lower rate tax payer over 65 with significant investment income may be better off transferring investments to an ISA as it could reduce total income and allow use of the Age Related Personal Allowance. The total benefit may not be huge but it's another part of the game.

Comment by robin4321 at 12:07pm on 24 Jan 2013:

As I understand it the income from investment trusts is classed as dividend which normally attracts dividend tax liability. Those trusts domiciled in the Channel Islands pay their dividend gross and the tax can be avoided by protecting them in ISA's or SIPP's.
Similarly dividend income from ETF's domiciled in Ireland can be paid gross and again protected in wrappers.
Is my understanding correct?

Comment by ivanopinion at 3:01pm on 01 Feb 2013:

I tend to favour putting in my ISA the funds with the highest yield, because the dividends would otherwise be taxed at the higher rate. With funds outside an ISA, you can't avoid tax on the dividend, but you often can avoid CGT on gains. If you are starting to build up unrealised gains greater than the £10,600 exemption, you can sell enough to trigger a gain equal to the exemption, then repurchase at the higher price, so the latent gain is reduced. This is known as bed and breakfasting. Do some research on Google so you properly understand how to do it without falling foul of tax rules.

Comment by ivanopinion at 4:53pm on 01 Feb 2013:

Another factor worth considering when deciding what to put in your ISA is whether there are any costs such as stamp duty levies or deletion levies or initial charges. For funds with these sort of charges, bed and breakfasting might not be viable if you have to pay a 0.5% levy, for instance. So, you might prefer to put these funds in an ISA, so that you don't need to worry about bed and breakfasting, because any gain when you ultimately decide to sell the fund will not be subject to CGT anyway.