Tax is one of the most important factors to take into account when you’re framing an investment strategy. It can take a chunk out of your investment returns, which at higher rates, can be painful, and when you take into account compounding, over time the effects can be significant.
If you can avoid paying tax on your investments, the benefits can be just as significant on the upside.
This is where Individual Savings Accounts (ISAs) have a vital role to play. They were introduced by the government in 1999 as a way of encouraging saving and investment with generous tax breaks.
You can pay up to £20,000 into an ISA in the 2019/20 tax year without paying tax on the interest earned or any capital gains.
So, you should certainly look at ISAs as part of your overall investment strategy.
The question is: which one? There are now no fewer than seven types of ISA, the main four being;
- Cash ISAs
- Stocks and Shares ISAs
- Lifetime ISAs
- Innovative Finance ISAs (IFISAs)
Another fundamental investment principle is diversification, so it’s worth considering a mix of these ISAs.
In this article, we will compare the Cash ISA and IFISA to better educate you on the choices available, as well as providing an overview of their benefits and downsides.
When should you invest into a Cash ISA?
Cash ISAs can be a really useful addition to your investment portfolio. You’re able to pay in up to £20,000 into a Cash ISA within the 2019/20 tax year, and you don’t have to pay tax on any interest that you earn.
There are three different types of Cash ISA - instant-access, fixed-rate and flexible.
Instant-access Cash ISAs allow you quick and easy access to your money, as and when you need it. Instant-access Cash ISAs would be a great choice for an investor who may need access to their money at short notice.
On the other hand, fixed-rate Cash ISAs mean your money is locked away for a fixed term - usually between one and five years - and in return you receive a fixed-rate of interest. Fixed-rate Cash ISAs will typically pay higher interest rates than instant-access Cash ISAs, but you must be sure that you will not need access to your funds before the term is up.
Flexible Cash ISAs allow investors to withdraw and replace money in their ISA within the same tax year without it affecting their annual ISA allowance.
When it comes to risk vs return, Cash ISAs are low risk - and considered to be the most secure ISA - and they are protected by the Financial Services Compensation Scheme (FSCS) for up to £85,000.
However, this security comes with the downside of lower returns than can be earned by other ISAs, such as an IFISA.
When should you invest into an Innovative Finance ISA (IFISA)?
Innovative Finance ISAs (IFISAs) were introduced by the UK government in 2016 in order to provide investors with tax free returns on peer-to-peer (P2P) loans and fixed term bonds.
P2P loans serve three key sectors - personal loans, small business loans and property loans.
With IFISAs, the projected rates of return range from 3% to 15% per year and they vary in terms of risk.
An IFISA allows you to use your tax free ISA allowance to lend funds through the P2P lending market and other debt-based securities, such as property bonds. It's important to note that Financial Conduct Authority (FCA) rules limit the amount that everyday (restricted) investors can invest into P2P investments to 10% of their investable assets, and only experienced investors classified as either sophisticated or high-net-worth individuals are eligible to invest into mini-bonds.
Property remains the second most important asset class after cash, and as such, it will always have an important role to play in any well balanced investment portfolio.
Property bonds held in IFISAs can also carry a further element of security as they can be secured against the asset whose acquisition or development they were issued to fund. This means that, in the event of failure or default by the issuing company, the bond holder has a legal right to the property. This can be sold to return some, or all, of their investment.
How do you choose the right type of investment method?
Cash is perhaps the safest form of investment, though its value can be eroded by inflation if the inflation rates exceed the interest paid on the cash.
However, being more secure means it will probably pay a lower rate of return than more adventurous forms of investment. As we’ve seen, a fixed-rate Cash ISA will most likely give a higher return than an instant-access Cash ISA because you earn a little more by agreeing to have your money tied up for a period of time.
On the other hand, IFISAs will carry a higher rate of return than even a fixed-rate Cash ISA and it will enjoy the same tax protection. But, the flip side of that is that it will be less secure. The company that issues a bond can go bust, or it may be forced to defer or suspend interest payments on its bonds if its business does badly. Even governments have been known to default on their bond repayments, as some holders of Greek government bonds discovered to their cost a few years ago.
It’s important to note that, unlike Cash ISAs, IFISAs aren’t covered by the UK’s compensation fund, the FSCS.
So, on the one hand, you have fixed-rate ISAs - these give you the security of holding cash, along with FSCS protection. Then, you have IFISAs, which have the benefits of a regular and predictable income stream and will usually pay a higher rate of return than a fixed-rate ISA, but they carry a higher degree of risk. This risk can be partly mitigated if your IFISA is asset- backed, against property for example. With both a fixed-rate Cash ISA and an IFISA, you have the generous tax benefits of a tax free allowance.
A third option when choosing between a Cash ISA and an IFISA is to choose both. Both have tax advantages and, as part of a balanced portfolio, can provide income streams over a spread of dates with a rolling series of redemptions to smooth cash flow.
The CARLTON Bonds product is available exclusively to experienced investors who are classified as either sophisticated investors, high-net-worth individuals or professional investors and have the knowledge and experience to make their own investment decisions. Investments are high risk and illiquid, your capital is at risk and returns are not guaranteed. Bonds are not protected by the Financial Services Compensation Scheme (FSCS).
Originally published 14th October 2019, updated 16th December 2019.