Tax tips for wannabe ISA millionaires

If you want to become an ISA millionaire, then you'll need to protect your wealth from the taxman.

Who wants to be an ISA millionaire? I wouldn’t say no myself! It’s certainly a nice problem to have, but building up a significant amount of wealth means you could end up with a big tax bill if you’re not careful.

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Here we take a look at how to save tax if you’re an ISA millionaire and just how much tax you might save.

How long to get to £1 million?

In this article, I’ll use Sam’s Benstead’s ISA calculations from earlier this week on how to become an ISA millionaire. If you start with £10,000 in your ISA and contribute £300 per month, it could take you 47 years to reach a cool £1 million, assuming investment growth of 6% (net of fees).

But how long before your decision to invest in a tax-efficient ISA wrapper pays off and you start saving tax? 

Dividend tax

With the tax rules changing in April, even people with small amounts of wealth might end up paying dividend tax if they don’t protect their investments in an ISA.

You can currently earn £2,000 dividend income each tax year before triggering a dividend tax charge, but that annual tax-free threshold is reducing to £1,000 in April 2023 and £500 in April 2024. Earn over that amount and you’ll have to pay 33.75% dividend tax on your excess income if you pay higher-rate tax, or 8.75% if you’re a basic-rate taxpayer. Additional rate taxpayers have to pay even more.

For our wannabe ISA millionaire, starting with £10,000 and contributing £300 per month, under the new £500 limit dividend tax threshold they would start saving on dividend tax straight away. In contrast, someone investing the same amount outside an ISA would pay £25 dividend tax in the first year, rising to £741 after 10 years, £2,149 after 20 years and £13,850 after 47 years (calculations assume 4% dividend yield, potentially achievable from UK stocks, and 33.75% dividend tax rate).

Over 47 years, an ISA millionaire could save a whopping £193,959 in dividend tax by investing in an ISA!

Capital gains tax

Likewise, the capital gains tax rules are changing this year to make ISA investing even more attractive. The capital gains tax annual allowance is reducing from £12,300 to £6,000 in April 2023 and to a measly £3,000 in April 2024.

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For our ISA millionaire, this means they could end up saving a huge amount of capital gains tax by the time they cash in their ISA. Take their initial £10,000 investment (worth £166,593 after 47 years with 6% investment growth): if they invested outside an ISA that could trigger a £156,593 gain, reduced to £153,593 by the CGT annual exemption and so a huge CGT bill of £30,718.

Inheriting an ISA

There is also a tax advantage when it comes to passing on wealth through an ISA. It’s possible to pass your ISA to your spouse and for them to still keep the investments within an ISA wrapper. They’ll get a one-off increase to their ISA allowance to allow them to treat the ISA as if it were their own.

Don’t forget your pension

Although an ISA is one of the simplest ways to protect your wealth from tax, there are plenty of other tax-saving opportunities for would-be ISA millionaires.

A brilliant alternative to ISA investing is using your pension to minimise your tax bill. You’re allowed to invest a maximum of £40,000 per year, up to your taxable income, unless you’ve already started drawing a pension income. In this case, the annual allowance is reduced to £4,000. Investing in a pension not only protects your investments from dividend and capital gains tax, but you’ll also get a tax boost when you pay in.

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For our canny wannabe millionaire, this tax boost could mean it only costs £180 to pay £300 into their pension if they’re a high earner. That’s because they would have paid 40% tax (£120) on their pension contribution had they taken it as income.

It’s true that investing in a pension is less flexible than an ISA: you won’t be able to draw money out until you reach 55, rising to 57 in 2028. But if you’re thinking long term and saving for a comfortable retirement, then using a pension usually makes sense.

For some, not being able to touch your pension wealth until you hit 55 could even be an advantage. There can be a temptation to dip into your savings if it’s easily accessible. But if it’s tucked away out of reach, then it’s easier to let it grow undisturbed. You could be one step closer to achieving your financial goals and a comfortable financial future.