An Innovative Finance ISA allows investors to earn tax-free interest by investing in peer to peer lending. The investment alternative was introduced in April 2016 by the UK government. P2P platforms with an ISA manager status and with permission from the Financial Conduct Authority (FCA) can offer IFISAs. Savers can spread their personal savings allowance (£20,000 for 2020/21) between different types of ISAs including cash ISA, stocks & shares ISA and IFISA. Just like other types of ISAs, you can only invest once in the innovative finance ISA per tax year.
Also, you can transfer your existing ISA cash from the past year into an IFISA. Plus, since interest is not taxed, you don’t have to pay tax on your capital gains.
How Peer-To-Peer (P2p) Lending Works?
Peer to peer lending allows investors to lend funds directly to individuals or businesses who need a loan. The p2p platform removes the middleman, which generally are building societies or banks. Therefore, the interest rates are much better for the lender and the borrower.
The peer to peer funding has gained a lot of popularity among the investors who want better returns on their funds while being able to take some risk. In the past, if you invested in a p2p platform, you had to pay interest on your loan returns by completing in a self-assessment tax return. However, now, the platforms that provide IFISAs allow investors to make investments tax-free. With this platform, you can:
· Manage risk by understanding the asset classes
· Diversify investment portfolio with peer to peer loans
· For your retirement strategy use an IFISA
· Potentially obtain a high return on your investments
Everything You Have To Know Before You Invest In an IFISA
IFISA investment is riskier compared to putting your funds in the conventional cash ISA. This is because the borrowers may default on their loan payments, and it can cause you to lose part of or all of your money. Typically, P2P lending companies have a process of selecting credit-worthy borrowers, and you are encouraged to spread the risk by dividing your investment between different borrowers.
To understand IFISA better let’s look at a scenario: if you invest your annual allowance of £20,000 in this tax-year and then every year for the next eighteen years with returns of 10% a year, your investment of £360,000 could turn into one million because of compounded returns and the tax-free wrapper.
Platforms providing IFISA charge the borrowers a fee instead of the investors, they remove the middleman that is the bank or fund managers, and offer high returns to investors. Also, some of the peer to peer lending platforms have a provision fund in place which can payout investors in case a borrower defaults on their loan repayment. Keep in mind that the funds you invest in an Innovative Finance ISA will not be covered by the Financial Service Compensation Scheme (FSCS), which protects the deposits of up to £85,000 if a firm goes bankrupt.
There are a few reasons to why IFISA may be the right investment for you:
- If you are fed up of low-interest rates of cash
ISA - You want to lock your savings away for a
certain amount of time - You understand the risk and returns
completely
Diversify Your Portfolio Based on Your Risk Appetite and Your Investment Goals
You can decrease the chance of risk by spreading money across different loans on the basis of your risk appetite and investment goals. For better diversification, it is a good idea to invest in a range of companies and industries.
If you are not going to access your returns for the medium term (i.e. five years), you can lend to venture debt campaigns to earn double-digit returns. On the contrary, if you are risk-averse, then you can lend into loans that are secured against property.
HMRC guidance for peer to peer lending
We have created a list of tax rules for p2p issued by Her Majesty’s Revenue and Customs (HMRC).
Key peer to peer tax rules
- Most people don’t have to pay income tax, because p2p lending is included in the ‘personal savings allowance’. That is tax-free interest of £1,000 for the basic rate taxpayers and £500 tax-free interest for high rate taxpayers.
- So, basic rate taxpayers would have to lend almost £12,000-£30,000 before being charged for tax and a high rate taxpayer would have to lend around £6,000-£15,000.
- Most people don’t need to declare their peer to peer earning to the HMRC.
- You will have to pay tax at your income-tax rate on taxable interest.
- The first £1,000 earned in interest from peer to peer lending and savings accounts is always tax-free.
- Anyone can lend tax-free using Innovative Finance ISA as the cost is the same as ordinary peer to peer lending accounts.
- All bad debts are tax-deductible.
- You can get an additional tax break if you earn less than £17,500 per tax-year.
- You probably won’t have to pay capital gain tax, but if you have invested a huge sum of money, then it is possible that you will have to if you buy and sell loans regularly for profit outside the pensions of IFISAs.
- Pension lending is also tax-free, but it is only suitable for people with large sums of cash to lend because of the high pension cost.
How can you invest in an IFISA?
There are a lot of peer-to-peer lenders available in the market. However, we are going to mention some of the best providers offering an Innovative Finance ISA:
- Kuflink
- Crowd2Fund
- CapitalRise
- Funding Circle
- Property Crowd
- Lending Works
- LandlordInvest
The interest rates for investments vary, so you have to ensure that you look around before you sign up.