How ISAs might change - Autumn Statement

THE rules and incentives governing savings may be up for review at the Autumn Statement next month (22 November).

Reports are emerging of an overhaul of the regime for ISAs, the flagship vehicle for tax-free saving and investing. Current rules allow adults to save as much as £20,000 into ISAs each financial year but underneath that headline allowance are multiple options for where to save, and intricate rules for how each ISA offering works. 

In a period when the government has little room for tax giveaways, tweaks to the system for savings may be a way to improve its financial offer to families.  

Here we examine some of the proposed reforms to ISAs. 

Cash vs investments 

Individuals can use their ISA allowance to save into cash or invest into other assets like shares and bonds, and they can do it in whichever proportions they choose. A long-term criticism of ISAs has been that a disproportionately high amount ends up in cash where returns have historically been lower than investments, albeit with no risk of nominal losses of value. 

You can see the dominance of cash inside ISAs from HM Revenue & Customs ISA statistics. The supremacy of cash has been slowly reducing but the number of new cash ISAs still dwarfs those of new stocks and shares ISAs.

^{Source: HMRC, June 2023.} 

One proposed measure intended to convert more cash savers into investors is to do away with separate cash and investment ISAs, and instead allow the free movement of funds from one to the other within one, single ISA. This would remove the requirement to open separate ISA accounts, potentially with different providers, if you want both cash and investment ISA savings. 

Such a change would not expand what can already be saved overall, or where, but it may reduce friction that can deter some from taking the step to invest. 

Extra ISA for British investments

A more radical change would be to provide a dedicated ISA allowance for investments that help the government support the UK economy. That could mean privileging the shares and bonds of companies listed in the UK, potentially improving the incentives for companies to float on the market here.  

Reports so far have suggested that such a plan is only at an early stage. One key question would be whether a chunk of the existing £20,000 is carved out and dedicated to UK-specific investments, or whether a new allowance is provided on top. 

A downside to the plan is that it would add to the complexity of ISAs, and the system is already criticised for being too confusing. There is also the question of whether it would encourage investors to make undiversified investments, leading to too great a weighting in the UK when a more geographically balanced approached would be more suitable.  

Additionally, there’s a risk that the aims of the savings regime become confused. The government offers tax breaks on savings - primarily via ISAs and pensions - because there is a public benefit in individuals improving their own financial security. Injecting another aim - of improving the corporate environment for UK companies - could lead to times when those two aims collide. 

Fractional shares

There are strict rules on the investments can be held in ISAs. Most listed company shares are allowed, either held directly or via funds. However, one recent development in markets has challenged the rules. 

‘Fractional’ shares are when individual company shares are divided up into chunks worth less than one single share.  Some share brokerages will divide shares in this way to create fractional shares that can be bought and sold for lower values. 

The potential benefit to investors is that they get to buy smaller stakes in companies if buying a whole share might be too much. For example, Apple’s shares currently trade for around $179 each. If you had only small amounts to invest, buying a single Apple share might mean you are too exposed to its performance. For this reason, fractional shares have been of particular interest to younger investors who have less money to lay down. 

Some share trading providers have offered to include fractional shares inside ISAs, but this has faced challenges from regulators who see fractional shares as falling outside of what is permissible. The Autumn Statement could be an opportunity for the government to clarify the rules and allow fractional shares within ISAs. 

Loosening Lifetime ISAs

Lifetime ISAs can be opened by anyone aged 18 to 40 to save up to £4,000 each year, with a bonus of 25% of whatever is saved added by the government. Contributions can be made until age 50.  

The money can be withdrawn and used in the purchase of a first home worth up to £450,000, or else after age 60. If money is withdrawn outside those circumstances a 25% charge is applied.   

Lifetime ISAs have proved successful for those able to use them within these narrow guardrails but there are increasing calls for the rules to be loosened because many are finding themselves penalised for reasons outside of their control. 

Critics include Martin Lewis, the financial campaigner, who has argued that the rules have become outdated since the Lifetime ISA was launched in 2017. In particular, the £450,000 cap on home purchases has not risen at all, despite average house prices rising by around 35% since then. 

If a first-time buyer wants to use their Lifetime ISA savings to buy a home worth more than £450,000 they face the 25% charge on their savings. This penalty not only wipes out the government bonus they would’ve received, but also takes 6.25% of their own contributions. 

As a result, Lewis has argued for the penalty on purchases above £450,000 to be reduced to 20% - meaning only the government bonus is removed - and for the £450,000 limit to then be reviewed each year in line with property price changes.  

End to Innovative Finance ISAs?

Innovative Finance ISAs were introduced in 2016 in response to the emergence of peer-to-peer investments. This primarily meant loans made by individuals to other individuals or businesses using platforms that were outside of the normal banking system. 

The idea was that savers could get better rates than cash accounts - and the Innovative Finance ISA made returns tax-free.  

Seven years on and the Innovative Finance ISA is at risk of being a flop, with just 17,000 opened in 2021/22 out of a total of 11.7m ISAs overall. High-profile failures of peer-to-peer platforms have undermined confidence, while the rates for savers have been unremarkable versus traditional cash accounts. 

If the government is motivated to tidy up the ISA regime and make it less complex, phasing out the Innovative Finance ISA could be one place to start.