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Flexible ISAs

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ISAs have been with us in some form since 1999 and, whilst the core principles of the tax wrapper remain the same, there have been a number of modifications and even new types of account introduced in the past 22 years. In the 2019/20 tax year, around 13 million adult ISAs received subscriptions totalling £75 billion. (Source: HMRC ISA statistics June 2021.)

They are attractive to investors as they offer tax efficiency and (in most cases) easy access to their savings and investments, as well as one easy-to-understand annual subscription limit. The Government favours them too, as they cost little in terms of upfront incentives but can also be used to influence behaviours, such as supporting the purchase of a first-time home.

An adult can subscribe up to £20,000 per annum across the different types of ISA offered, with the Lifetime ISA (LISA) having its own yearly payment limit of £4,000 for those who are eligible.

Whilst there are four types of ISAs available to split the £20,000 limit between, investors can only subscribe to one of each type per tax year.

In April 2016, the ability to operate a flexible ISA was introduced as an ‘add-on’ to the adult ISA framework. This article explains what a flexible ISA is, gives examples of how the flexibility works in practice, and offers a discussion on which clients and investors could make the best use of it.

What is a flexible ISA?

A flexible ISA is an ISA where the terms and conditions allow the investor to replace (all or part of) the cash they have withdrawn, without the replacement counting towards their annual subscription limit.

Once the value of the withdrawal has been replaced, any further subscriptions will then begin to count towards the annual subscription limit.

As an example:

Clare subscribed £20,000 to her ISA in May 2021. It is now November 2021, and she wishes to make a withdrawal of £5,000.

Under normal ISA rules, any cash she withdraws from the ISA could not be paid back in as she has already used her annual subscription.

However, if the ISA operated flexible ISA terms and conditions, Clare could replace up to the amount withdrawn (£5,000) in the same tax year without breaching her annual subscription limit.

Offering ISA flexibility is optional for ISA managers. However, it is not available for Junior ISAs or Lifetime ISAs.

Where the terms and conditions of an ISA offer flexibility, the ISA manager should put a ‘flag’ on the annual return of information to indicate the terms and conditions permit flexibility. The flag should be used regardless of whether the investor has used the flexibility.

Flexible ISA withdrawals

The investor can only make a withdrawal under flexibility from a cash ISA, or from cash held in a stocks and shares or innovative finance ISA. This could be the cash proceeds from the sale of any investments held.

Flexible ISA withdrawals are treated as being made from current year subscriptions first, followed by any previous year funds.

If income is being paid out from a flexible ISA directly to the investor (either on the instruction of the investor or as part of the account terms), this will count as a withdrawal which can be replaced without counting towards the subscription limit.

However, there are some types of cash payments that will not count as flexible withdrawals, even when made from a flexible ISA. These include money removed to cover fees and charges, or money removed by HMRC to cover a tax debt or via a court order.

Replacement subscriptions

No applications or declarations are required under the rules for an investor to make a replacement subscription.

The replacement subscription can only be made in cash, with an exception in the form of shares where they are transferred from a schedule 3 SAYE option scheme or schedule 2 SIP.

In contrast with the priority order of withdrawals, replacement subscriptions are treated as replacing the previous year’s funds first, and then cash subscribed in the current year.

I’ve explained how withdrawals and replacement subscriptions work in practice using the three possible ISA accounts that you might encounter with clients.

i) Flexible ISA with current tax year funds only

Money withdrawn from a flexible ISA will be from current year funds only and can be replaced before the end of the same tax year without using any more of the investor’s annual subscription allowance.

The replacement subscription could be to another ISA, but the investor must not be subscribing to another ISA of the same type in the tax year as a result of the replacement.

Where a flexible ISA has current year subscriptions only, any withdrawals over and above the amount subscribed – for example, income or capital growth – can only be replaced in that ISA.

Where a replacement subscription from a flexible ISA is made to a Lifetime ISA, this will count towards the Lifetime ISA payment limit (but not the annual overall ISA subscription limit).

Example

Mahmood subscribed £20,000 to his flexible stocks and shares ISA on 6 April 2021. On 1 November, the value of the investments is £22,000 and he sells investments and withdraws cash of £21,000. His ‘net’ current year subscriptions at this point are £nil and he can use his full annual subscription allowance of £20,000 between his stocks and shares, or any cash ISA, Lifetime ISA or IFISA he subscribes to in the tax year. However, the withdrawal over and above the amount subscribed of £1,000 (£21,000 - £20,000) can only be replaced in his stocks and shares ISA.

ii) Flexible ISA with previous tax year funds only

Money withdrawn from a flexible ISA containing the previous year’s subscriptions can be replaced (up to the value of the withdrawal) and will not use any of the current year’s subscription allowance, but only if paid into the same account, in the same tax year.

iii) Flexible ISA with subscriptions from both current and previous tax years

Withdrawals will count against any money subscribed in the current year first, with any excess being treated as coming from a previous year.

Upon replacement in the same tax year, the previous year’s subscriptions will be treated as being replenished first, followed by those made in the current year.

The ISA manager does not need to record whether a replacement subscription relates to current or previous year’s subscriptions.

When a withdrawal closes the ISA

If the withdrawal closes a flexible ISA, then the ISA manager would need to reopen the ISA to accept a replacement subscription before the end of the tax year. This might not always be possible and would depend on the ISA manager’s terms and conditions.

Flexible ISA transfers

As with all ISAs, the value of any current year subscriptions (known as the current year account) must be kept together on transfer. This means any current year account must be transferred in full.

The transferring ISA manager will tell the new ISA manager what subscriptions have been made in the current year upon transfer. With a flexible ISA, this will be the net subscription value – the amount paid in less the value of withdrawals from the flexible ISA. If the withdrawal was greater in value than the current year subscriptions, the total net subscription for the current year will be recorded as £0 upon transfer. Subject to any subscriptions made to other ISAs in the year, the full balance of the annual subscription limit will be available with the new manager.

Any replacement subscriptions made to the new ISA in the same tax year will count towards the annual subscription limit.

Where the transfer comprises only the previous year’s ISA subscriptions, any withdrawals not replaced before the time of the transfer cannot be replaced with the new manager without counting towards the current year’s ISA allowance. They could however be made with the transferring ISA manager in the same tax year as the withdrawal if they keep the ISA open.

Future of ISAs

ISAs have become more complicated over time, particularly with the introduction of the Lifetime ISA, but despite this they are still viewed by the public as relatively simple.

At present, ISA flexibility is primarily offered by cash ISA managers, although there are a few stocks and shares providers which are currently offering or in the process of introducing the option.

ISA flexibility does create added complexity and reporting for the ISA managers which chose to offer it and this, coupled with a lack of investor and adviser demand, has been cited as the main reason not to offer it.

However, there are cases where flexibility could prove a valuable option and might even act as a further incentive to use cash currently languishing in bank accounts to invest in ISAs.

Whilst clients will be advised to have emergency cash funds available to avoid dipping into accounts invested for the long term, circumstances could require access to accounts at short notice and the ability to replenish the accounts further down the line could be attractive.

The pandemic and support packages available shone a light on the self-employed savings and investments gap and the need to make provision for both the long term and for short-term shocks. Even in ‘normal’ times, self-employed people often face a higher risk to their cash flow than the employed, so the comfort of the ability to draw on and replace investment accounts as a buffer could incentivise further saving and investment in good times.

If ISA flexibility engages saving and investment further, then does that make a compelling case for making it a mandatory feature across the traditional ISA landscape?

This article was previously published by FT Adviser

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Charlene Young
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Charlene Young

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Senior Technical Consultant

Charlene is a Chartered Financial Planner with over 10 years' experience in financial services. She joined AJ Bell in 2014 after relocating to Manchester from Bristol, where she held financial planner and paraplanner roles at leading firms. In addition to analysing and commenting on technical and regulatory issues, Charlene is also responsible for designing and providing technical training for AJ Bell staff.

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