Why is the government going to tax your Isa?

Kat Cereda: Some of the cash in your ISA could be taxed at 22% from next April. So what does this mean for your savings portfolio? Let's find out on this episode of Which? Money.

Hi, I'm Kat in the Which? studio, standing in for James, and I'm pleased to be joined today by Which? Money's investing expert, Josh Wilson.

Josh Wilson: Pleasure to be here.

Kat Cereda: And AJ Bell's director of public policy, Tom Selby.

Tom Selby: Hello.

Kat Cereda: So a little bit later we're going to be talking about what the new PM might mean for investments. But first, Josh, remind us first, what's happening to ISA allowances in April next year?

Josh Wilson: Yeah, of course. So for starters, at last year's budget, the Chancellor, Rachel Reeves, announced that the allowance on cash ISAs was going to be cut from £20,000 down to £12,000 for under-65s. And that's due to come into effect next April – so 2027. And the more recent announcement is that because they changed the allowances on cash ISAs, they were worried that this would prompt people to move a lot of their cash into stocks and shares ISAs, where you can earn interest if you just hold cash in a stocks and shares ISA. So what they've done to discourage this is they've introduced a 22% charge on the interest that you earn on cash held in stocks and shares ISAs. And that's due to come into effect from April 2027.

Kat Cereda: And Tom, this is meant to be part of the government's push to get more of us investing, isn't it? Because the stocks and shares ISA limit is remaining at 20k.

Tom Selby: Yeah, so that's the stated aim. So the government has said it wants to encourage a greater retail investing culture in the UK. Now, there were different ways they could go about that. I'd argue the way they've gone about it has been slightly cock-handed and not the most sensible way to do it. So what they've gone for is the kind of the big stick of tax and punishment in order to get people to invest. So rather than saying we want to encourage people to invest, they're saying they're going to limit the opportunities for you to grow your cash tax-free within a cash ISA and instead they're saying we're going to hope that people use that extra £8,000 of allowance to invest in a stocks and shares ISA and, as was just mentioned there, if you don't do what the government wants you to do, which is invest, then we're going to hit you with a 22% tax charge on the interest.

Now, it's something that we pushed back pretty hard against. So Labour came into government saying they wanted to simplify ISAs. I think we can all agree this is not simplification of ISAs at all – a different ISA limit for two different products, different rules if you're over 65 versus under 65 and a new tax charge within ISAs. It's not ideal and I think our strong view was that actually there's no evidence that people are going to use stocks and shares ISAs to work around this cash ISA allowance cut, and it would have been much better for the government at the very least to wait for a year or two and see if there's any evidence that people are looking to work around the intent of the cut in the cash ISA allowance by piling money into stocks and shares ISAs.

I think realistically it would have been pretty unlikely to happen because obviously we've lived in an environment of really high interest rates recently, exceptionally high, way above the Bank of England's target, and so one would expect interest rates to come down over the long term, and these are supposed to be long-term reforms. And if we move to a world where interest rates are around the 2% mark that you'd expect them to be, then the returns that you'd be able to get via this work-around would be somewhere in the region of 1% to 1.5%. Now, I think platforms like AJ Bell and the investment industry generally should be able to challenge itself to encourage more people to invest to beat a 1% and 1.5% guaranteed return on your cash – that shouldn't be a difficult thing to do. But the process of the government coming up with these reforms has not been great and they've clearly decided that the risk of people working around those reforms was too great and so they've come up with these complicated sets of measures to try to force people to do what they think is the right thing for them.

Kat Cereda: Josh, you were nodding along to that. Do you agree that it's potentially a misjudged decision to implement this?

Josh Wilson: Well, if I'm honest, I am in agreement with Tom on this. I think there was already an issue where there were several different types of ISA, which already introduces confusion for someone who's interested in saving their cash or investing their cash – what are the differences between them? And now they've also added more confusion by changing the allowances, but only for some types of ISAs and not others, and then introducing this 22% tax on interest you earn on cash, but only the cash that you hold in a stocks and shares ISA. So I just think, especially for someone who's not a very experienced investor when it comes to investing and cash and this kind of thing, it just makes it much more difficult for you to get into that whole world and to understand how it works. So yeah, I do think it's a bit of a problem.

Tom Selby: It's worth saying they're not calling the 22% tax a tax, because there were concerns that if you call it a tax, then ISAs won't be able to be promoted as tax-free to people, which is one of the key things that have attracted people to ISAs over the last 20 years. Ironically, two of the key things have probably been the simplicity and the fact that they're tax-free, and you could argue that these reforms undermine both of those things. So they're calling it a 22% charge and they're saying that ISAs can still be promoted as tax-free by firms.

But clearly, whether you call it a tax or a charge, it makes it less attractive for people to hold cash within stocks and shares ISAs. And one of the challenges of that is that, well, firstly, there is very, very little money held in cash within stocks and shares ISAs anyway, and there are legitimate reasons why you need to hold cash within a stocks and shares ISA. So you need cash to pay fees. If you're working towards a purchase – so I think the government has always viewed the idea of de-risking as linked it to age, so it's something that older people do in retirement. But actually, if you use an ISA, for example, to save for your kids' university fees, then you're going to want to reduce the risk in those investments and ultimately move to cash when you get to the point that you need to pay those fees. So it means that people ultimately will be punished to an extent for using ISAs in the way that they have to be used.

It's an argument that we and many, many others have made to the government, but it's fallen on deaf ears, unfortunately. So we haven't got the final rules yet, we've got the intent of the rules, but this is what we're all going to have to deal with from April next year. And I think it will be on providers like AJ Bell and others to explain these decisions to people and to be very clear that for the vast majority of people using a stocks and shares ISA for long-term investing is still the same experience as it would be before, but you've just got this slightly annoying tax charge that exists, and also potentially a reduction in some of the lower-risk investments that you can choose as well.

Kat Cereda: Yeah, so it's fair to say that this is going to be very frustrating for investors. But 22% seems quite steep. Why do you think the penalty is so high?

Tom Selby: Well, so I think it is to align with penalties that exist within the system. And it's also worth pointing out that it's 22% on the interest that you earn. So this has actually been a common misconception, understandably so, because this is all quite complicated. So it's not that you'll pay 22% of your entire portfolio value, it will be 22% on any interest that you earn. So actually for a modest portfolio, you might only be talking about an interest charge over the course of a year of £10, something like that, £10, £15. But it's as much as the impact it has on people's finances, and that's clearly not nothing, it's the message that it sends to people that this is a more complicated process and there are going to be charges that are levied on you, even though you're going to have to have money in cash anyway at certain points in time, that make the messaging around it quite tricky.

Kat Cereda: So do you think this potentially is going to deter people from investing? Because if they feel like their money is just going to be resting in the account and potentially getting charged on the interest, they might feel rushed into making the investments that they're going to make as opposed to having the time to think about it?

Tom Selby: So that's the big risk and this is something that we and others communicated to government throughout the process of them designing these reforms. Clearly if you create a new charge that wasn't there before, then someone may feel, oh, not understand how that works, and may think, well, if I'm going to pay a charge in there, actually I'll just have my money either just stick to what I'm putting into my cash ISA or I'll save it elsewhere and subject it to tax in the usual way. So that will be a challenge. And as we've noted as well, it's the complexity of the whole thing. So lots and lots of people don't invest for the long term because there's lots of jargon involved, it feels quite alien to them, and so any barrier that you put in place of people doing something which might not feel inherently natural to them is a problem.

Kat Cereda: Just a bit more intimidating.

Tom Selby: Exactly, it makes it much more intimidating, more complicated. There's more stuff for us as providers and for you as journalists to explain to people, and the more barriers that are in place that you have to say, oh, by the way, if you have your money in this way then it will be charged in this way, but if you have it in this way it won't be, and there's this allowance over here, but it's different for this group of people over here, oh, and if you're over 65 it might be a bit different again, you can imagine an ordinary person will just go – this is not for me, it just proves it's not for me, I knew this was too complicated and I just can't be bothered dealing with all of this.

But that behavioural side, it feels like has just been completely lost in the government's approach to these reforms. It's been very much a Treasury-focused, how do we frame the tax system and allowances in order to shove people in the right direction, rather than considering how retail investors behave and how do we nudge and encourage them to do things which fundamentally are in people's best interests. So over the long term, holding cash has been proven to be a terrible investment strategy, and investing is a really good investment strategy over 5, 10 years, if you've got the long-term time horizon, then it makes sense. But getting to that message is just a little bit more difficult now than it was before because you've got all these rules that you need to explain to people first.

Kat Cereda: Yeah, so that certainly sounds potentially quite alienating for some people. But let's talk through how it will work in practice. So if you hold any cash in a stocks and shares ISA, will you face a tax bill?

Josh Wilson: So this depends on the amount of interest that you're getting paid on the cash that you hold. So when you hold cash in a stocks and shares ISA, generally that stocks and shares ISA will be held within an investment platform, and certain investment platforms will pay you a particular amount of interest on that cash that you hold. Uninvested – it's important to say that this is uninvested cash. So if you have that cash and it's invested in assets like shares or investment funds, then this won't apply to any of that. But if you hold the cash uninvested and you earn interest on it – so 1% interest or 2% interest – that you're being paid by the investment platform, there will be this 22% charge on that interest that you earn. And the details of how that charge will be collected, well, essentially you yourself won't actually have to do anything, the investment platform or the asset managers will remove that charge on your behalf.

Kat Cereda: But Tom, it's not just cash, is it? Investing in certain funds have got some new rules going on. Can you talk us through those?

Tom Selby: Yes, yes. So this has been again subject to much debate. So when these reforms were announced, or shortly after they were announced, the government said it wanted to look at anti-circumvention measures to prevent people working around that cash ISA allowance cut. So the first one was a ban on transfers from stocks and shares ISAs to cash ISAs, because otherwise people would just be able to fill up their stocks and shares ISA and then move the money immediately into a cash ISA product. So that was always going to be necessary. The second was that tax charge on the interest on cash held within stocks and shares ISAs.

And then the third one was restricting what they call cash-like investments. Now, this third one was particularly controversial, because you had the issue of how do you define what is cash-like and not cash-like. So these are very low-risk funds that invest in instruments that essentially act and behave in a similar way to cash, but they are investments, they're just at the lower-risk end. So what the government has said, and we don't have the detailed rules for this yet, but what they've said is that if someone is 100% invested in what's called money market funds – so these are funds that are very similar to cash – then that won't be eligible for a stocks and shares ISA. So firms – so providers like AJ Bell and others – will need to set up systems to notify people that if they've got all their money in a money market fund, or several money market funds, that isn't allowed under the rules, and they need to change their investment, and if they don't change their investments, then ultimately that will become ineligible for an ISA and their money will be divested.

We don't have the detailed rules yet on exactly how that's going to work, we're expecting to see that in the next few weeks, so firms like AJ Bell and others can implement the changes. I think the good thing with this is that at least it's only people who are sticking everything in these lower-risk assets, so the concern was that anyone who was looking to invest in a cautious fund, for example, because they're looking to de-risk, and that cautious fund might hold money market funds within it, would either be subject to a tax charge or they would just say you can't do that anymore, which would undermine very sensible retail investing principles. So they haven't gone down that road, which is useful. We still think this is completely unnecessary and actually the number of people who hold all of their money in money market funds will be really low, but the Treasury have clearly deemed that they need to do something to show that this kind of behaviour isn't one they want to see from ISA investors, but it's not as bad as it could have been, but still another challenging thing to communicate to people and more complexity within these reforms as well.

Kat Cereda: Yeah, it sounds like there's a lot up in the air still. But, Josh, another change is from next year we will no longer be able to transfer a stocks and shares ISA into a cash ISA. What do you think is the thinking there?

Josh Wilson: The thinking there essentially is that, as Tom said, they don't want people to just pile up money into a stocks and shares ISA and then transfer it into a cash ISA, which would circumvent the – if you're under 65, the allowance on a cash ISA has been cut from £20,000 to £12,000. So this would potentially be a way around that where you put £20,000 into a stocks and shares ISA and transfer that over, that whole £20,000 into a cash ISA. So that's the thinking behind it. But as Tom was saying, this all just adds a load of complications and confusion about what the rules are, and the rules for different types of ISAs and how they work, and it's just going to make it really difficult for anybody who's not an experienced investor to be able to follow what's going on along here.

And I think another issue is when they cut the allowance on cash ISAs, I don't think they really thought this change through and the further impacts that it would have. You can clearly see that with this whole thing with stocks and shares ISAs. This all feels kind of like ad-hoc policy that's just done on the fly. And if you're an investor and you're looking at this, you're just going to be like – what's going on here? And you're also going to be like – what's going to happen in six months' time? Is there going to be a bunch of new policies introduced because of problems that have arisen from this new set of changes? And it it it's just not good. It's not good.

Tom Selby: That's really well said. And I mean, interestingly, one of the biggest loopholes that exists with these reforms has never been tackled, and we're starting to see the impact of that in the numbers that are coming through. So because the change was announced at last year's budget, people know that they've got until April next year to make the most of a £20,000 cash ISA allowance before it goes down to £12,000. Now, one of the best kind of things that you can use if you're looking to market a financial services product is scarcity. And everyone out there knows that the cash ISA allowance is about to go down. So what do you think ordinary people who have £20,000 to put into a cash ISA and aren't into investing are doing at the moment? They are piling all of their money into cash ISAs, which is exactly the opposite of what the government wants to do.

Now, they could have done something to stop this. If they had thought this policy through, then they could have looked to introduce anti-circumvention measures ahead of the introduction of the cut in the cash ISA allowance. They could have looked to ban transfers ahead of that introduction. But the reality is that they haven't thought it through, so they haven't done any of that stuff, and we're seeing in the official figures that come through month after month after month that, having announced policies intended at encouraging retail investing, customers absolutely rationally are doing exactly the opposite. Now, the Treasury will argue over the long term hopefully people will start to invest. But over the short term, the impact has been more people having money in cash when the aim is to have more people investing, and it was always going to be the case, but because these reforms weren't particularly well thought through, the Treasury weren't able to come up with a way to prevent that and that's kind of where we are now.

Kat Cereda: So it sounds like there's still a lot to be announced. But am I right in thinking that people can head to which.co.uk to keep updated and find out what the changes are?

Josh Wilson: Yep, we'll be staying on top of this and any changes that come along, we will be writing about those. So, yeah, stay tuned and we will provide you with all the information and coverage that you need.

Kat Cereda: So staying on the topic about investing, people are obviously going to be keeping a close eye on the markets. We're likely to get a new PM in the coming weeks. So, Tom, are we expecting uncertainty in the markets?

Tom Selby: So there's uncertainty in the markets pretty much always. And there has been a lot of uncertainty over the last 10 years since the EU referendum and before that even. Clearly, changing Prime Minister creates a certain amount of uncertainty. It's always worth remembering that when it comes to investing, you're looking at the global environment. So what has been happening in Iran, for example, has had a far bigger impact on people's investment values over the short term and their portfolios than a change at the top of the government that hasn't even happened yet.

So, yes, there's uncertainty. I think the big uncertainty is around what would a presumptive Prime Minister Andy Burnham's approach be to tax policy. I think the bond markets are looking very closely at that. I think the question will be who does he appoint as Chancellor and how cast-iron are those fiscal rules that Rachel Reeves has signed up to. Andy Burnham's been trying to be as clear as possible, I think, that they will stick to those fiscal rules, that there isn't going to be a huge spending splurge, which might scare the bond markets, which might see interest rates rise. But until we know the shape of his government, who his Chancellor is going to be and frankly until we get to a first major fiscal event, i.e., a budget, which we'd expect later this year, it's very hard for the markets or individuals to know the extent to which this is going to make a difference to the way government goes about policy and particularly policy linked to their personal finances.

Kat Cereda: Well, I was hoping you guys would help me understand something. I feel like we haven't been able to escape the phrase "in hock to the bond markets" as people have speculated about Andy Burnham's fiscal policies. What does it mean? Tell us.

Josh Wilson: So, as you said, we're about to get a new Prime Minister and it's almost certainly going to be Andy Burnham, the former mayor of Manchester. And there's been a lot of stuff in the press recently suggesting that the bond markets, they don't like Andy Burnham, they're going to curtail whatever economic policies that he might want to introduce. And as for Andy Burnham himself, he has previously said that Britain needs to not be in hock to the bond markets – the so-called bond vigilantes, as some people have called them. But to what extent is this true? To what extent do the bond markets really control government finances and fiscal policy?

And this is a really interesting discussion and debate and I think the first thing to really talk about is what do the bond markets want? You know, what do bond investors want? Essentially, they want to know that they're going to get their money back. So if they buy government bonds, which also known as gilts, they want to know that they're going to get a return on their investment, they're going to get their money back. And if you look at government bonds at the moment, so the UK 10-year gilt rate, which is the amount of interest that you would get back if you bought a bond, it's currently hovering just under 5%, which is quite high for recent history. It's also important to think about how much debt the UK government is currently in. It's currently in about £3 trillion worth of government debt, which is quite a lot. That's about 100% of GDP.

There are two kind of theories – well, there's more than two, I'm going to talk about two of the big ones – about bond markets, the influence they have and what you could do to kind of curtail it. On the one hand, you've got a bit more of a materialist approach, which an economist like Gary Stevenson would kind of put forward. He would talk about the fact that government debt is very high, which means that bond investors are going to be a bit cagey when it comes to buying bonds from the government, they're going to demand higher rates of interest on those government bonds. And part of the reason we've got ourselves into the situation is the government has kind of over the past sort of 30, 40 years has divested a lot of its wealth, you know, it's sold off the utilities, it's sold off community centres, and a lot of that wealth has ended up in the pockets of very rich companies, very rich individuals. If you do that, if your economic policy is to hand over your wealth to rich people and then borrow it back in the terms of them providing public services back to the public, you are giving a huge amount of power over to those people who you have sold those assets over to, right? So he would argue that if you want to deal with the bond markets, and if you want to curtail the amount of power and influence they have over your economic policy, the only way to deal with it is taxes on the very, very rich, to bring some of those assets back into government ownership through taxing the very, very wealthy. When I say the very wealthy, we're talking about multi-millionaires, billionaires here, not like the middle class, the upper-middle-class.

And the reason he argues, and an economist like him argue that the bond markets would not react adversely to a wealth tax is because it would if it was well planned and you had that level of sound economic planning, because that's one thing the bond markets really like is they like a coherent economic plan that you stick to. So if you do these wealth taxes, and you do it as part of a coherent economic plan, that will reassure the bond markets, so the theory goes, because they would have confidence that they would get their money back on their investment. So that's that's one theory on the bond markets.

The other one, which is kind of more the theory of Modern Monetary Theory, which an economist like Richard Murphy would talk about, is to say that the bond markets don't have any real power because the UK government we've we're a sovereign currency. We have a sovereign currency, which is controlled by the Bank of England, and the Bank of England is controlled by the Treasury, which is controlled by the government. So the UK government, under Modern Monetary Theory, can't ever go broke because it can always pay down its debts because it always has its own currency. And now some critics would say, okay, but if you just printed money to pay off these debts, it would lead to inflation. But there are again MMT argues that there are ways to deal with this through taxation, through the selling of bonds to bond investors, which takes money out of the economy, which stops runaway inflation. And again, one of the things you can do to prevent this is to have some kind of wealth tax in place to prevent too much money accumulating in the hands of a very small number of people. I'm really interested to see what kind of approach Andy Burnham takes and to what extent he's going to feel that his hands are tied by the bond markets. So we kind of have to wait and see a little bit.

Tom Selby: Yeah, I'd just add to that, I think that the argument around the bond markets and the influence they have can get quite kind of technical and involved. In reality, the bond markets are gravity. It's the reality of the consequences of the choices that any Prime Minister is going to make. Now, I think for certain people that's an uncomfortable truth. I think often you'll see the bond markets are kind of described as being wealthy people who are holding who aren't democratically elected, who are essentially making government decisions. They're not, as you've just said, it's about all they want ultimately to make sure is they're getting a return on their investment. And if you as a government do something that makes people think you're less likely to be good for that money, then the interest rate goes up. Now, that doesn't stop Andy Burnham or anyone else doing whatever they want to do. It just means that there are consequences. So if you massively increase government spending and you don't have a credible plan to fund that increase spending, then investors, bond investors, will think that you're more of a risk than you were before and the interest rate will go up. You can still do that. There's just the consequence to your action.

And I think lots of people would like to think that you can do some of these things without there being consequences. You can't. We're in huge amounts of debt as a country, we have been for a long time. That is just a reality, and politicians are still democratically elected and they can still do whatever they want, as Liz Truss and Kwasi Kwarteng proved, but as Liz Truss and Kwasi Kwarteng proved, there are consequences to doing things when you don't come up with a credible way to pay for what you're going to do. So yeah, very, very difficult for Andy Burnham and whoever his Chancellor is to fundamentally move the dial on some of these things. He's clearly nervous about the bond markets and that's completely reasonable because they will react to any sense that there's uncertainty about how good the UK government is to pay off its debts, and so that leaves him in a way he's in the same him and his Chancellor are going to be in a similar straitjacket as Rachel Reeves and Keir Starmer were in, and I suspect are going to be in a similar strategic position as they were in, which is hoping that we get growth. And then because if we get growth, then you can make these decisions without making painful tax decisions.

But that didn't work out too well for Keir Starmer and Rachel Reeves. It's possible that he'll be a lucky general and things will get better, the growth figures before the Iran war were pretty positive, so maybe he'll be able to ride that wave, maybe AI will help make everything more productive and won't lead to mass unemployment and as a result things will be easier and you'll be able to hand things out because the finances look better. But as Rachel Reeves saw, it can go the other way. Anything could happen in the next few years which could completely undermine those goals as well. And as I say, the bond markets are just the reality that every government has to face when it's making tax and spend decisions.

Cat: So do you think it's fair to say that he's unlikely to do much change in policy anytime soon? I know he's said that he's going to stick to the original Labour manifesto pledges, but he might be looking to make his mark, I don't know, what do what are your thoughts?

Josh Wilson: Mm, I mean, a lot is going to kind of depend, you know, we'll get a really clear idea of his economic policy, his views on economics, when he when he comes into office, and when he appoints his Chancellor. That'll give us a clearer idea of kind of where he wants to go. And I wouldn't I wouldn't necessarily rule out that he would make changes to government fiscal policy. Whether he does anything extreme is you know, I think it's unlikely that he would do anything too crazy. But at the same time, we are in a bit of a situation here where the government is in a lot of debt. It doesn't have very much wealth left to its name, in terms of assets. It's lost a lot of those assets.

And we are really in a position here where governments kind of they're going to have to do they've got three options on the table, really, which is: one, they tax the super-rich; two, they tax working people and the upper-middle-class and the middle class; three, they shut down the welfare state. And you can really see that they're doing two of those things at the moment – they're shutting down the welfare state, and they're taxing working people, middle-class people a lot more. They really need to think Andy Burnham really needs to think when he comes into office, is he just going to do more of the same – more austerity, more fiscal rules, more tinkering around the edges, which you saw it with you saw it with Keir Starmer, you saw it with Rishi Sunak, you saw it with Liz Truss, you're seeing it around the world, you saw it with Joe Biden in America, you're seeing it with Merz in Germany right now, more of this technocratic tinkering around the edges.

It's it it doesn't it doesn't wash, it doesn't wash with people when living standards are getting worse and worse, people are really struggling with the cost of living crisis, people really want to see change, people really want to see change, and if Andy Burnham doesn't deliver that, if he just does more of the same technocratic stuff, people are going to continue to get poorer, inequality is going to continue to go crazy, and he will fail, and he will fail, and you will see Labour their popularity tank, Andy Burnham's popularity will tank, and you'll end up with Nigel Farage and Reform in the next election. That's how it will go.

Cat: Wow, well, I've certainly learned a lot today, given us a lot to think about and obviously we're going to be finding out more over the next few weeks, months, and I'm sure we can go to AJ Bell and which.co.uk to keep updated and find out more. So, Tom and Josh, thank you very much for your time.

Josh Wilson: Thanks so much for having me.

Tom Selby: Thank you.

Kat Cereda: That brings to an end another podcast from Which? There's loads more for you to read about everything we discussed today – just head to the episode description for more useful everyday advice. There you'll also find an exclusive offer for podcast listeners like you to become a Which? member for 50% off the usual price, giving you access to our product reviews, our app, one-to-one personalised buying advice and every issue of Which? magazine across the year. Plus your membership helps us to make life simpler, fairer and safer for everyone.