The NISA Rules

Disclaimer: Even though NISAs don’t go live for another 2 months (June 2014) this articles refers to ISAs by their new name, NISAs. Why the government felt they needed to re-brand ISAs I will never know!

NISAs form a key part of my investment portfolio and plans to retire early. Particularly in these times of all time low interest rates any yield I can get from my capital needs to be shielded from the tax man in order to maximise the benefit. Below I set out the NISA rules I follow.

Rule#1 – Always Max Out Your Allowance

If you want to build a money tree then you need to treat your NISA allowance as a very precious thing. Unlike virtually all other savings vehicles (including pensions) any income generated by your NISA is untouched by income tax. If you’re saving for the long term in particular and are looking to generate a future income stream from your NISA then this tax benefit should be a massive attraction for you.

With dividends you receive a 10% tax credit when you receive them (this takes into account that companies pay dividends out of post tax profits). This means that if you’re a basic rate tax payer you won’t have any additional income tax to pay.

However if you pay higher rate income tax you’ll have to pay HMRC an additional 25% of the dividend income via the self assessment process. However if you stash your savings and investments in to a NISA you get to keep all of it! As a result it pays sense for higher rate tax payers to stuff as much cash into their NISAs as they can.

Rule#2 – Use Your Partners Allowance

If possible always try use both yours and your partners NISA allowance each year. The starting allowance per person for NISAs is £15,000 so you’ll need £30,000 in disposable income to be able to do this. Even if you can’t afford to use both allowances every year, still bear this rule in mind if you have any financial windfalls (inheritances, gifts, work bonuses etc) in the future.

Rule#3 – Use Your Allowance at the Start of Each Year

If you want to benefit from the wonders of compounding dividend income, then the sooner you get saving the more benefit you’ll ultimately get. If you are in a position to be able to use and invest your NISA allowance at the start of each tax year (on the 6th April) then you’ll benefit from an extra years worth of income that this years allowance brings you.

If you’re investing the new £15,000 NISA allowance at the start of the year, and you manage to achieve a yield of 5%, by the end of the year you could expect to have another £750 worth of income producing assets working for you in the future.

I’m lucky enough to receive an annual incentive bonus from my employer¹. This usually gets paid sometime in February so when bonus day comes round I’m looking to earmark as much of any bonus I get as is humanly possible towards my next NISA allowance, around 8 weeks later in April.

Bonus or not, in the weeks running up to April I will be emptying out the penny jar, checking down the back of the sofa and ebaying furiously to raise the funds to fully invest my NISA allowance on day 1.

Rule#4 – Don’t Ever Draw Down

Try not to think of your NISA savings as regular savings. Regular savings are usually earmarked to be spent on exotic holidays, car repairs, home improvements, flat screen TV’s etc and tend to be spent every now and again. Instead get in to the habit of trying to think of your NISA savings as a future income generating machine.

The more NISA savings you have, the more future income it will generate for you. Assuming your NISA yields 5%, then for every £10,000 you deposit, you could expect it to generate you £500 each year, or approximately £42 each month. If you spend any of money invested then your future income stream will reduce, for ever.

Therefore it pays to plan on never spending down your NISA capital, certainly not until late in life.

Rule#5 – Re-invest Your Income

Having resolved to never draw drown your savings, your next resolution should be to re-invest all of the income generated for as long as is possible. Thanks to the tax break on income generated within a NISA you can re-invest it each year which has the same effect as increasing your annual allowance.

Of course at some point in the future you’ll most likely want to start drawing the income (and maybe some of the capital) you’ve invested over the years. Until you reach that point you should aim to re-invest all of the income generated in order to maximize the compounding effects and long term benefit.

Rule#6 – Invest Tax Free Lump Sums

If you’re about to retire and you’re going to take a tax free lump sum from your private pension scheme then stashing some of it away inside a NISA is a great place to put it. Don’t forget that any income taken from a pension is taxable (at the standard tax rates/bands) so using some of your tax free lump sum to fill your NISAs can be a great way to get some money out of your pension and into a vehicle that will allow you to take the income free of tax.

Of course don’t forget that pensions are big complicated beasts so don’t take this one as written. This one won’t be the best solution for every retiree, so be sure to do your own research first.

Rule#7 – Don’t Lose Your Capital

The tax benefits of ISAs are precious and you don’t want to lose them. Once you’ve used your allowance you can’t get it back so it makes perfect sense to be cautious and avoid investments where your capital is at risk. At the same time the main benefit of a NISA is they are income tax free. Therefore NISAs are more suited if you’re running an income investing strategy.

If you’re going to be making value style investments (seeking price appreciation rather than dividend income) then you may want to consider making these sorts of investments outside of your NISA. If the company you’re buying in to doesn’t pay a dividend then you won’t be liable to pay any income tax so they can be held outside of your NISA.

Just remember that any investments outside of a NISA will most likely be subject to capital gains tax. However you’ll need to be making some pretty substantial gains to be affected by this –  the 2014 threshold is £10,900.

If you’ve already got value investments (I wonder how many in the UK have bought Facebook shares² in their NISAs) in your NISA you may want to consider selling them and using the proceeds to buy more income investments inside your NISA. If you still want to hold your value investments then you can re-purchase outside of your tax free wrapper.

Notes:
¹to date!
²Facebook don’t pay a dividend currently