Martin Lewis has highlighted little-known rules around ISAs and when they could attract a tax bill, including an important three-year time limit after which ISA holdings may incur an HMRC charge. Speaking on his BBC podcast, he explained how ISAs work when a person dies.
How ISA tax-free status works
The key benefit of ISAs is that any growth within these accounts is entirely tax-free. Mr Lewis explained: "Basically ISAs protect you from the current tax that you have on them. So in a Stocks and Shares ISA, any capital gains—so that's the gain that you make on a profit, any profits that you make when you sell it—they are not there because it's sheltered within an ISA wrapper."
He added: "Income tax on dividends is pretty much the same as savings, you know, making interest on savings. So if you're getting income tax on dividends from your funds or shares within your Shares ISA, again that is protected."
Mr Lewis also noted that ISAs do not count towards other tax allowances: "Remember ISAs not just aren't taxed, they're not taxable, so they don't count towards your other allowances, your personal allowance, or anything like that aren't sheltered." The personal allowance means you can earn up to £12,570 each tax year without paying tax, and any income from an ISA will not count towards this.
The three-year rule after death
However, the taxman may come knocking when assets are passed on. Mr Lewis told listeners: "But when you pass an ISA on when you die, it is part of your estate." As such, it is liable for inheritance tax.
He explained: "Rule number one, the ISA status, when you die, stays tax-free—a continuing account until administration of the estate ends or the third anniversary of death, whichever comes first, but no new money can be paid in. So it stays tax-free. When it's moved on, then it counts towards your inheritance tax allowance that we talked about earlier, £325,000."
Each individual can pass on up to £325,000 in total assets without paying inheritance tax, plus an additional £175,000 allowance. Unused allowances can be passed to a spouse or civil partner, potentially allowing up to £1 million in assets to be passed on tax-free. Inheritance tax is charged at a standard rate of 40 per cent.
Special rule for spouses and civil partners
Married couples and civil partners can benefit from an extra tax perk called the Additional Permitted Subscription (APS). Mr Lewis said: "There is a special rule for your spouse or civil partner—so your married or civil partner, not cohabiting, not your kids—that they can get an extra ISA allowance of the same as your allowance when you died."
The APS lets the surviving partner claim an additional ISA allowance equal to the value of their partner's ISAs at death. Mr Lewis gave an example: "So if you've got £50,000 in ISAs, they can get an extra £50,000 tax-free ISA allowance." The surviving partner gets this extra allowance up to three years from the date of death, or up to 180 days after the estate is settled.
Another perk is that ISA savings can be passed to someone else while the partner keeps the tax allowance. Mr Lewis explained: "And interestingly, I could give my child the money [from the deceased person's ISAs], but I could still pass the allowance on to my spouse."
To access this allowance, the surviving partner must contact the bank or building society directly. Mr Lewis said: "They [the surviving partner] can apply for it, but it's worth noting you have to apply to your ISA provider to get it, and not all ISA providers will allow you to have it." If the provider does not offer the APS, the ISA can be transferred to a provider that does.
ISA changes coming soon
Some key rule changes are taking effect soon. Currently, you can pay in up to £20,000 a year into ISAs, divided as you see fit between different types. From next year, the allowance will be £12,000 to use however you want, with the other £8,000 only available for deposits into investment-based ISAs like stocks and shares ISAs. People aged 65 and over will retain the current £20,000 allowance, qualifying for the full amount in the tax year they reach 65.
