Over the last few years, Peer-to-Peer lending has become increasingly popular. It offers solid returns compared to what you can get with a standard savings account at your high street bank, and this is no surprise a growing number of investor have started dabbling in alternative finance.
On the other hand, higher returns also mean higher capital gains, and tax liability. This is particularly crippling for taxpayers in the higher tax bracket. When money starts compounding, and growing every year, over the course of a few decades, even a few percent difference on the actual rate of return can mean thousands of pounds lost to the tax man.
In 2017, Peer-to-Peer investors received great news, as Innovative Finance ISAs were launched. The acronym IFISAs for short means that you can now protect your capital gains from taxation, and do so legally.
As of April 6th 2018, the Individual Savings Account allowance for the 2018/2019 tax year remains unchanged compared to 2017/2018, at a generous £20,000.
You can decide to split that allowance however you see fit between a Cash ISA, a Stocks and Shares ISA, an Innovative Finance ISA, and so on. The total amount spread between all these account cannot exceed the yearly allowance.
Now let’s do a little exercise to see where your money should go.
If you decide to put some of your allowance in a cash ISA, the best interest rates around are in the 1.50% to 1.75% range. Say you really luck out and find a cash ISA paying 2% per year.
You invest your full allowance, or £20,000. At the end of the year, the interest earned on your savings is £400.
For simplicity, we will assume all fund were invested on the first day of the tax year.
If you are in the 40% tax bracket, having invested your money in a cash ISA represents a saving of £160.
Not too bad, but let’s see what happens if you invest your money in Stocks and Shares or Innovative Finance instead.
Let’s now assume that you place your £20,000 in an IFISA such as the ones from Just ISA, that pays 8% pa interest.
At the end of the year, your £20,000 produced £1,600 in interest, and your tax saving if you are in the 40% bracket would be £640, or £480 more than the cash ISA example.
Do nothing else, and keep your £20,000 compounding at 8% every year for the next 20 years, and you will have £98,536.
Invest outside of the IFISA and you will only have $51,081 after 20 years.
That is how powerful compound interest is, and how taxes can affect returns and prevent compounding.
While you can’t go over the limit of your annual allowance, you can generally transfer the ISA balances from previous years and start earning tax free interest.
It is important to know the risks and not invest money you can’t afford to lose. Keep a balanced portfolio and some cash in your accounts so you don’t have to dip into your ISA for an emergency. But if you want to maximize your tax breaks, putting your investments with the higher rate of return into your ISA is what makes the most sense.