Investing for income in your Isa – what, why and how to get in early

The weeks around April are often referred to in personal finance circles as "Isa season". That's because the deadline to use your tax-free allowance ended on 5 April - and early birds will have started investing their new year's allowance soon after 6 April.

If you have money to invest, the best way to do it may well be through an Isa. You'll get the same benefits as any other investment account, plus some tax advantages to boot. Here's everything you need to know.

How much can I put in my Isa?

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There are several types of Isa – cash Isas, investment Isas and a couple more – and you’re allowed to invest up to £20,000 combined across all your Isas in the 2017/18 tax year.

Because the Isa limits are aligned to the tax year, you have until 5 April next year to contribute up to the limit.

What can I put in my investment Isa?

Investments eligible for inclusion in an Isa include company shares, investment funds (also known as unit trusts or open-ended investment companies), exchange-traded funds, shares in investment trusts, government bonds (known as gilts), corporate bonds, and shares from the smaller-company exchange the Alternative Investment Market, or Aim.

What is income investing and why would I consider it?

In general - and irrespective of how you invest - you can make two types of return from your investments: capital growth and income.

Capital growth is when the sell price of the assets you hold increases – in other words, when the share price goes up and increases the value of your portfolio.

Income is money paid out to shareholders and bond owners. Companies sometimes divvy up part of their profits among shareholders in the form of dividends, while bond holders receive income in the form of periodic, predetermined interest payments. Note that unlike bond returns, dividend payments are not fixed - they depend on the profitability of the company and the decisions of its board, which means they can be volatile but also potentially lucrative.

Reinvesting income (turning dividend payments into yet more dividend-paying shares) is an extremely powerful way to get your returns rolling up and your portfolio growing in value. Coupled with the tax advantages, the benefits are hard to deny.

Wait. Tax benefits?

Yes. Within an Isa, any growth in your investments is free of tax. This means that it doesn’t matter how much income you make, you will never have to pay tax on any of it if it’s in an Isa.

Outside the Isa wrapper, savings income of £1,000 in a given tax year can be earned free of tax. A note here for new investors: £1,000 is quite a lot. Most income-centric investment funds pay out

percentage yields in the low single-figures, so to get £1,000 of dividend income at a yield of, say, four per cent, you’d have to have £25,000 invested.

Because the amount you can put in your Isa is limited, this could take you a while to reach that tipping point – but once you do, you’ll be glad your money is housed inside a tax-efficient wrapper.

Also, since Budget 2017 those looking to invest in income-yielding shares should look again at Isas. The dividend tax allowance was reduced from £5,000 to £2,000, meaning for investments help outside of an Isa the tax-free limit on investment income has been reducing by 60 per cent, raising £2.6bn for the government.

What should I invest in?

That decision is your alone. However, in general the more diverse your portfolio is the better protected it will be from the vagaries of one market or the other.

Some countries have more of a dividend-paying culture, as well. Large companies in the UK and Australia often pay out half of their earnings or more as shareholder dividends. The US practices this as well, although not quite as enthusiastically.

European companies have over the last few years been increasing their dividend payouts as well in a bid to entice investors.

What’s this I hear about trusts?

Investment trusts or investment companies are like funds, except they have a limited number of shares available (whereas a fund can create or destroy its own units). This is why they are called "closed-ended" funds - as opposed to "open-ended" unit trusts.

What this means in turn is that a trust’s share price can rise and fall, as well as the prices of the underlying shares.

But trusts also often pay out dividends, and many pride themselves on having gone many years with consistently rising dividends – decades, in some cases. This is partially down to the trust’s ability to retain income to pay out later in the lean years, but even so they present an interesting opportunity for the income seeker.

Often a manager will have both a unit trust and investment true following the same investment strategy, so it's always worth checking out which has the best track record of returns.

That’s me sorted – but what about the kids?

You’re in luck. Any child under 18 can own a junior Isa, which is exactly the same as a regular Isa except you can put less away (£4,128 this tax year). The eligible investments and tax advantages are the same, except that when the child turns 18 the Isa grows up too, into a fully-fledged adult tax wrapper owned by the child.