Acc/Inc fund in ISA or outside

sebtomato

Hi,

I already have an ISA fully subscribed, so I am looking at opening another account to have investment funds outside of an ISA.

I am currently thinking that, given that capital gains are not taxed below a certain threshold, I would be better off having accumulation funds outside of an ISA (so that I can get some of the gains tax free if I need to sell), and income funds inside of an ISA (so that income is not taxed).

Is that a correct assumption from a tax view-point?

I am not too clear on whether reinvested income outside of an ISA would be taxable, or if it's the same as an accumulation fund, where income is automatically reinvested.

Thanks,
S.

masonic

There is a difference between income that is paid as a dividend (no tax liability for basic rate payers) and interest (such as from a bond fund, which is taxed like bank interest). It is somewhat irrelevant whether you buy accumulation vs income units as the liability will still be there for income that is capitalised rather than distributed. Most Acc funds paying interest will automatically deduct basic rate tax (which can be reclaimed or arranged to be paid gross inside an ISA).

Mistermeaner

masonic wrote: »

There is a difference between income that is paid as a dividend (no tax liability for basic rate payers) and interest (such as from a bond fund, which is taxed like bank interest). It is somewhat irrelevant whether you buy accumulation vs income units as the liability will still be there for income that is capitalised rather than distributed. Most Acc funds paying interest will automatically deduct basic rate tax (which can be reclaimed or arranged to be paid gross inside an ISA).

Hi, forgive my ignorance but as a high rate tax payer with acc funds held in an isa do I need to do something to make sure tax is treated properly?

Appreciate my platform knows it's an isa but the fund manager won't.... Will he?

sebtomato

So let's assume a bond fund has a yield of 5%, and is an accumulation fund.

Do you expect only 4% to be automatically reinvested in the fund, as 20% tax on interests would be taken before the reinvestment?

masonic

ggb1979 wrote: »

Hi, forgive my ignorance but as a high rate tax payer with acc funds held in an isa do I need to do something to make sure tax is treated properly?

Appreciate my platform knows it's an isa but the fund manager won't.... Will he?

It's up to higher rate taxpayers to declare the notional income accumulated within the fund and settle the liability with HMRC. Since yours is in an ISA, you don't need to do anything.

masonic

sebtomato wrote: »

So let's assume a bond fund has a yield of 5%, and is an accumulation fund.

Do you expect only 4% to be automatically reinvested in the fund, as 20% tax on interests would be taken before the reinvestment?

Yes, that's how funds normally work outside of an ISA. Within an ISA, for some funds you would later receive a tax credit for the value of the tax deducted. Other funds have unit classes where interest is reinvested gross that platforms can use within ISAs. The fund prospectus usually tells you about the tax treatment that applies to the fund.

Mistermeaner

masonic wrote: »

It's up to higher rate taxpayers to declare the notional income accumulated within the fund and settle the liability with HMRC. Since yours is in an ISA, you don't need to do anything.

Do I need to do anything to recover the 20% that may have been deducted?

masonic

ggb1979 wrote: »

Do I need to do anything to recover the 20% that may have been deducted?

Not normally. For bond funds paying interest you'd normally receive tax credits automatically or be enrolled in the gross version of the fund. Having said that, I've been chasing Interactive Investor for missing tax credits on M&G Optimal Income Acc since Christmas (they were already aware they needed to issue the credit, but still haven't got around to doing so) so some platforms are better than others!

Edit: To be absolutely clear, most funds pay dividends, not interest, so in those cases nothing is reclaimable.

bowlhead99

ggb1979 wrote: »

Do I need to do anything to recover the 20% that may have been deducted?

No - the ISA provider will claim it back. Like Masonic said in the post directly above yours: either what you have is a special class of the fund where income is reinvested gross, in which case nobody does anything, or fund will be paying out net and the ISA provider will go and get you the extra cash which was originally withheld at source.

You're right that your platform knows its an ISA (or a SIPP, same principle) and your platform knows whether the fund pays interest to you, so your platform should sort it out. There will sometimes be a natural delay within this process but you'll get it in the end

sebtomato wrote: »

Hi,

I already have an ISA fully subscribed, so I am looking at opening another account to have investment funds outside of an ISA.

For simplicity, if you're holding any funds outside of an ISA, make them income/distribution versions rather than accumulation versions of whatever fund you want to hold.

Outside an ISA you have to track all your costs and sales proceeds to work out your gains for CGT (even if you don't go above the annual CGT exemption amount, you have to keep records to prove that you don't...).

So, if you can physically see the interest or dividend income being paid to you, and you can physically see it being reinvested in that fund or into another fund, it is very easy to track what you spent on any of the funds so you know the true cost to compare with the eventual sales proceeds.

By contrast, if you use a fund that internally accumulates and reinvests its distributable income, and just announces notional dividends and reinvestment without you seeing it, it can be quite tricky five or ten years later to work out exactly what your fund actually 'cost' when the money was reinvested ever quarter or half year or year without it touching your cash account.

Similarly it is harder to forget to pay your income taxes (if any, e.g. when a high rate taxpayer) on the income received, if you do physically receive them in a cash account. So if you want to make sure you don't miss it, it's much easier to be able to look at the cash account and see "ah yes, I got £40 of net distribution in May and another £70 in November" - rather than having to remember to dig out the individual vouchers at the end of the tax year from some electronic or paper-based filing system.

As Masonic said, the choice of Inc vs Acc as a fund type does not change the tax that's due, only whether it's doing auto reinvestment on your behalf. So if you're using a platform that doesn't cost lots of transaction fees when you want to manually reinvest, it's easier to use Inc outside an ISA or pension - although Acc makes sense inside a wrapper because there's no paperwork needed and nothing for you to manually need to fiddle with.

Beyond that tip for the fund class inc/acc, there are also some sensible planning things to minimise overall tax on the actual fund types. Funds which hold a high proportion of bonds will pay (or accumulate) their distributions as interest, which is, generally, going to cost most high rate taxpayers 40% tax. Funds that pay or accumulate their distributions as dividends, are going to cost less than 40% tax because divs are taxed at a lower effective rate. And funds focussed on growth might not be paying out any dividends at all so you would only be dealing with capital gains, which can be manageable with a decent annual exemption.

So the priority for filling your ISAs could be:
-interest paying funds first
-high income dividend funds next
-higher growth funds last

That's the traditional advice. BUT you'll find that over the majority of the economic cycle, i.e. over the long long term, returns from interest-paying funds will be lower than equity income or equity growth funds: lower risk, lower reward.

This means that if you put £50k into bond funds within an ISA and left them to grow at 5% for a decade they would end up being worth 'only' about £81k. If you instead used equity funds growing at 8% for a decade they would get to £108k. This means your total ISA wrapper would be a third bigger! So if you have a limit on how much you can practically fit into your ISAs, there can be benefits to using higher growing funds in the ISAs even if they are not saving a lot of tax. The compound growth of the better-performing funds inside the ISA is really helpful and can give you an overall improved financial position.

Of course if you're not lucky enough to be able to max out your ISA wrappers out of your salary every year then you will have space to move the better-performing funds into the wrapper over time anyway. So you might start by aiming to save the most tax each year (bond funds in the ISA first) and then squeeze the income funds into the spare space as and when you can.