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 the effects of compounding, over time the effects can be significant.
It follows that, 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 to encourage saving and investment with generous tax breaks. You can pay up to £20,000 a year into an ISA without paying tax on the interest earned or on any capital gains.
So, you should certainly look seriously 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; and IFISAs.
Another fundamental investment principle is diversification, so it’s worth considering a mix of these ISAs.
Fixed Rate Cash ISAs
A useful addition to your investment portfolio could be a type of Cash ISA called a Fixed Rate ISA. As with other ISAs, you can pay in up to your ISA allowance each tax year – in 2018/2019, that’s £20,000, and you don’t have to pay tax on any interest you earn.
When you put your money into a Fixed Rate ISA, you’re agreeing to lock it away for a fixed term – usually one, two or five years. In return, you’re guaranteed a fixed rate of interest for that term. Compared to Instant Access ISAs, which give you access to your money whenever you want, fixed rate ISAs often offer better interest rates. Apart from the better return, it could be useful to have an asset in your portfolio which gives a regular and predictable income stream.
Fixed Rate Bonds
A possible alternative to a Fixed Rate Cash ISA is a Fixed Rate Bond.
A bond is fixed income certificate that represents a loan, in other words, it’s like an IOU. They’re issued by governments, companies and other institutions to raise money. The investor lends their money to the issuer, which commits to repay the amount loaned – the face value of the bond – when it matures. The bonds also pay interest, at a fixed rate, if it’s a Fixed Rate Bond.
The best alternative to a Fixed Rate ISA is a Fixed Rate Bond held in an IFISA, an Innovative Finance ISA. The IFISA was introduced in 2016 in order to extend the ISA tax benefits to the growing peer to peer lending market. The IFISA allows individuals to use some, or all, of their annual ISA investment allowance to lend funds through the peer to peer lending market and buy other debt based securities, such as Fixed Rate Bonds, and they’ll still enjoy the ISA benefits of tax-free interest and capital gains.
How to choose the right type of investment method?
Cash is perhaps the safest form of investment. Its value can be eroded by inflation, if the inflation rates exceeds 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 such as equities. As we’ve seen, a Fixed Rate ISA, will probably give a higher return than a simple Cash ISA, because you earn a little more by agreeing to have your money tied up for a period of time.
A Fixed Rate Bond will carry a higher rate of return than a Fixed Rate ISA and, if it’s held in an IFISA, will enjoy the same tax protection. But, again, the flip side of that is that it will be less secure. A company which 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.
Not only that, but, unlike cash ISAs, IFISAs aren’t covered by the UK’s compensation fund, known as the Financial Services Compensation Scheme, FSCS.
However, Fixed Rate Bonds held in an IFISA have another advantage. They include property bonds, which are issued by a company to fund property projects, including the purchase of land or properties, development finance and planning finance.
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 can also carry a further element of security in that they can be secured against the asset whose acquisition or development they were issued to fund. So that, in the event of failure or default by the issuing company, the bond holders have a legal right to the property, which can be sold to return them some, or all, of their investment.
So, on the one hand, you have Fixed Rate ISAs, which give you the security of holding cash and the FSCS guarantee. On the other hand, you have Fixed Rate Bonds held in an IFISA, which also have the benefits of a regular and predictable income stream, will pay a higher rate of return than Fixed Rate ISAs but carry a higher degree of risk. This risk can be partly mitigated if your Fixed Rate Bond is a property bond secured against property. With both the Fixed Rate Cash ISA and Fixed Rate Bond held in an IFISA, you have the generous tax benefits of an ISA.
A third option when choosing between Fixed Rate ISAs and Fixed Rate Bonds in an IFISA is to choose both. Both have the 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.