Why withdrawing funds from your ISA should be your last consideration

A tax-efficient means of maximising returns, subscribing funds to an ISA – whether that’s a Cash ISA, Stocks and Shares ISA, Innovative Finance ISA (IFISA) or Lifetime ISA – renders returns free from income tax and capital gains tax.

But there will come a time when it becomes necessary to move funds from one ISA to another, or to decide what to do with your capital when the fixed term of an ISA product ends. In these circumstances, withdrawing funds from the ISA wrapper will most often be the least financially effective and beneficial option - and here we explain why.

Funds withdrawn from an ISA immediately lose their tax-free status

The tax-efficient benefits of an ISA are second to none, but when funds are withdrawn from an ISA wrapper, their tax-free status no longer stands. 

Read more:

If an investor withdrew, for example, £10,000 from a Cash ISA and decided to reinvest into another ISA the next day, the funds would be deducted from their annual ISA allowance.

This means withdrawing your capital from an ISA should be your last consideration if looking to maximise potential returns and make the most of the tax-saving advantages afforded by an ISA – unless, of course, you need access to the funds for a purpose other than reinvesting. 

But if the intention is to reinvest – whether into the same kind of ISA with another provider, or a different ISA product altogether – there is a method of doing so which allows capital to retain its tax-free status, and which avoids additional usage of the ISA allowance. This is called an ISA transfer.

It is worth highlighting that some ISAs come with a level of flexibility that can mean withdrawals are possible, without affecting your annual allowance, on the assumption the funds you withdraw are replaced within the same tax year. 

This is not something that is offered as standard across all providers, and it isn’t available at all in some instances. Where it is available, it can often incur additional charges (as well as requiring you to have the confidence you will be able to return the funds, otherwise you risk them losing their ISA status).

Transferring an ISA retains capital’s tax-free status and does not count towards your annual ISA allowance

When deciding to move funds from one ISA to another, we know some investors forget about ISA transfers. When following the official ISA transfer process – which differs from provider-to-provider – allocating capital to a different ISA can be done without deducting from your annual ISA allowance or losing its tax-free status. 

Remember: do not attempt to transfer an ISA by withdrawing funds and reinvesting them yourself. An official process must be followed, otherwise it will be classed as a withdrawal and reinvesting will contribute towards your current ISA allowance. 

An ISA transfer can be particularly useful for investors who have become disillusioned with the rock-bottom interest rates offered by Cash ISAs, resulting in the decision to consider adding more risk into their portfolio in order to target greater returns. This can be through a Stocks and Shares ISA, or for those investors wanting to avoid the volatile nature of the stock market, an IFISA, which has a similar risk–return profile and target returns, but with less volatility.

If the end of a fixed term is approaching, it is still possible to keep funds within the ISA wrapper

For investors holding an IFISA, the end of a fixed term brings with it multiple options when deciding what to do with invested funds. And again, unless the capital is needed urgently, withdrawing from the ISA wrapper should not be the go-to. 

Read more:

 There are often three choices when an IFISA investment matures – reinvest in the provider’s latest IFISA offering, transfer out, or withdraw.

Let’s first consider reinvesting. At the end of your investment’s term, you will likely be able to reinvest with the same provider if you wish to do so. Your provider should get in contact with details on how to do this, and it will not involve withdrawing and reinvesting manually – it should be a simple process whereby funds remain covered by the tax-free ISA wrapper throughout. 

In this case, the reinvestment also does not deduct from the annual ISA allowance. 

For example, investors into CARLTON Bonds Series Two – which matures on 31st March 2021 – could reinvest their original capital (with or without interest added) into CARLTON Bonds Series Five and Six without it affecting their current ISA allowance. This is because the original investment was made in a separate tax year and the capital has never left its tax-free wrapper. 

If the intention is to invest funds into an alternative ISA after the end of the fixed term, the ISA transfer rules mentioned above apply. If facilitated correctly, this is another means of retaining invested capital’s tax-free status, maximising returns and negating impact on the ISA allowance. 

Then, there is the option to withdraw the funds. Bear in mind that this will strip capital of its ISA-related benefits, and if it is to be reinvested at a later date, the subscription will contribute to the annual ISA allowance. 

With the above covering the three main options, there is also a fourth that can prove beneficial to understand - and that’s to do nothing. At least temporarily.

For those unsure of what they wish to do with their funds next, an appropriate option could be to simply do nothing. This means the funds will sit within the ISA wrapper – uninvested and generating no return – ready to be reinvested when the time is right.

It is important to reiterate the funds won’t be generating a return, but crucially, they won’t lose their ISA status either. This shouldn’t be seen as a long-term option, but it can be ideal if you’re considering how to use your funds and haven’t yet finalised your decision.

Avoiding ISA withdrawals has the potential to be extremely lucrative

Remaining consistent with ISA investments and avoiding withdrawals has the potential to be very lucrative. Utilising the annual ISA allowance in full whenever possible and taking advantage of reinvestment and ISA transfers instead of removing funds from their tax-free wrapper has resulted in numerous actual ISA millionaires.

Compound interest means after years of making the most of their ISA allowance, some investors are now sitting on a sizeable, completely tax-free sum. 

Whilst it’s important to remember that some ISAs – including the Stocks and Shares ISA and IFISA – are investment products, meaning capital is at risk and returns are not guaranteed, the benefits of holding an ISA (or several) are clear. 

And although it’s fully appreciated that in some scenarios withdrawing your funds will be the right option, the reality is it doesn’t need to be your first option - and in order to reach the full potential an ISA has to offer, withdrawals really should only be made if the funds are needed for an alternative purpose at that specific moment in time.