Labour set to slash cash ISA limit. Is it the right approach?

For several months rumours have swirled that Chancellor Rachel Reeves is weighing up a cut to the cash individual savings account (ISA) allowance.

And speculation went into overdrive yesterday, after the Financial Times reported the Chancellor is likely to announce the radical and controversial move at her Mansion House speech on 15 July.

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Reducing the cash ISA limit by any amount would be far more than a minor tweak. It would represent the biggest shake up to the ISA system for more than a decade, when George Osborne introduced several significant reforms at his 2014 Budget, which included equalising the cash ISA allowance with the stocks and shares version.

The thinking behind the move, which wouldn't be warmly welcomed by many savers who cherish the tax wrapper, is that more of the £300 billion sitting in cash ISAs would be better placed in the stock market, helping to stimulate the UK’s flatlining economy and boost savers’ returns in the process.

How much could the Cash ISA limit be cut?

Under the current regime, you can tuck away £20,000 every year into either a cash or stocks and shares ISA and shield any gains, interest and dividends from tax. The investment version accounts for around 60% of the £700 billion+ market value, while cash ISAs make up around 40%.

There are various reports about what the cash ISA limit might reduce to. Some believe it will be halved to £10,000 while others reckon Reeves could be more aggressive, slashing it to just £4,000. Reeves recently confirmed the overall £20,000 allowance will stay.

Needless to say, the prospect of restricting how much you can save into cash every year tax-free has split the crowd and sparked some rather fierce debate. On one side, we have financial firms craving a bigger piece of ISA pie, and on the other, building societies not wishing to forgo theirs.

A case of financial firms feathering their own nests? Perhaps. But there’s also a broader debate at play, one that focuses on consumer outcomes.

The saving versus investing debate

The problem isn’t that people are using cash ISAs – they’re a wonderful way to meet short-term goals and cover emergencies and not pay tax – it’s whether they’re being used for the right purpose.

History tells us that the stock market offers better returns than cash over longer time frames, so seeking ways to coax more people to invest is a laudable and important aim. Last year we crunched some numbers and found if you’d maxed out your ISA allowance every year between 1999 and 2024 and kept it in cash, you’d have a pot of £365,000. In contrast, investing that money in the MSCI world index would’ve returned just shy of £1 million (£987,000).

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It’s no exaggeration to say that’s a lifechanging disparity. Of course, the past is no guide to the future, and we should note that for much of that period, interest rates floundered at rock bottom lows.

Cash is often seen as a ‘risk-free’ approach, but that notion is flawed. The nominal value of your sum may not move up and down, but if the interest you receive doesn’t keep pace with inflation, the buying power of your savings will erode. And when it comes to accumulating wealth, the goal shouldn't be to merely match price rises but beat them.

Can this funnel more money into the UK stock market?

That’s the hope for the government, and although it’s possible, there is no guarantee this aim will be achieved. Those who use cash ISAs because they crave certainty and security, with that portion of their portfolio at least, may stick with cash as an asset, but either stick more in things like premium bonds or turn to tax-paying accounts.

Saving tax should never be the chief consideration when choosing a financial product. That’s not to say it isn’t important – less tax means more money for you – but suitability ranks higher.

Otherwise, more money would plough into venture capital trusts (VCT) and enterprise investment schemes (EIS) which offer generous upfront tax perks, rivalled only by pensions. They certainly have a place for the right type of investor, but most of us swerve them as they're not appropriate. Despite the attractive tax savings and prospect of outsized returns, investing in start-ups means they're at the racier end of the scale and charges can be high. Not everyone is happy with that level of risk.

Could the ISA system become more complicated?

The government has encouragingly pledged to simplify the ISA system, which has become rather convoluted and confusing in recent years with six types now in operation. Fiddling around with some annual limits may fly in the face of Labour's goal here. 

Adding to the potential complexity, it would presumably prohibit transfers from stocks and shares to cash, as was the case before 2014. In absence of this, savers could circumvent the system, filling up their remaining £10,000 allowance in the shares version and immediately switching the balance to a cash ISA.

Engaged investors may point to the role of money market funds as a home for short-term holdings – a low-risk way to keep your money wrapped up in a stocks and shares ISA but take volatility off the table. The problem is that less experienced investors may not be aware of their merits, and returns are slightly less predictable than cash.

How have previous cash ISA allowance changes impacted saver behaviour?

The most recent tax year where both the cash and stocks and shares allowances differed was 2013-14, when you could put £11,520 in total into ISAs, but only £5,760 into the cash version. To use the full allowance, you had to invest the rest.

But at his 2014 Budget, then-Chancellor George Osborne ripped up the ISA landscape, increasing the overall limit to £15,000 and allowing you to stick the lot in cash. The result can be seen in the table below. While the overall number of ISA subscriptions actually ticked down marginally, the amounts subscribed to cash ISAs jumped a whopping 57%, despite interest rates sitting at just 0.5%. By contrast, volumes into stocks and shares ISAs rose 20%.

Source: gov.uk

This data isn’t hugely surprising as the cash ISA allowance effectively tripled from one tax year to the next. And in the following years, the gap between the number of accounts and volumes subscribed has narrowed significantly.

But it does seem to indicate that savers are sensitive to cash ISA limit changes. The question now is whether a smaller amount will result in more money piling into the shares version.

Is the new FCA initiative a better solution?

The Financial Times report arrived hot on the heels of another big development. Yesterday morning the Financial Conduct Authority (FCA) kickstarted its eagerly awaited targeted support consultation, an initiative that aims to allow financial providers to guide consumers towards sensible financial decisions and products.

This initiative seeks to act as a halfway house between making your own investment decisions and taking regulated financial advice, allowing providers to nudge you in the right direction without making a bespoke recommendation. Only 9% of people take financial advice every year, and many of those who don’t would benefit from some help when making sound choices with their money.

This looks set to be a real gamechanger, particularly for less experienced investors seeking to select the right assets within their ISA wrapper.

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The FCA has listed some scenarios where targeted support could help consumers, notably those who should invest rather than save. For instance, a firm could suggest a specific investment product for a consumer who appears ready to invest, such as a stocks and shares ISA instead of a cash one.

I would argue that better financial education and guidance will have the greatest impact when seeking to transform more savers into investors. This may in turn boost the UK economy as investors often veer towards a domestic bias when constructing their portfolios. Axing stamp duty on UK shares could have an equally big effect, but tax cuts seem distant for a government with such narrow fiscal headroom.