The innovative finance ISA (ifisa) can be a powerful tool for building a tax-efficient portfolio in 2024-25. Yet, not all investors are integrating it prudently into their wider investment strategy.
Below, we offer an updated guide to the innovative finance ISA, how it compares to other tax-efficient “vehicles” (like the Enterprise Investment Scheme) and where it can fit into an investor’s overall goals.
What is the Innovative Finance ISA?
You are likely familiar with the ISA (individual savings account), which allows UK tax residents to earn tax-free interest, capital gains and dividends.
But how does the Innovative Finance ISA work? Here, investors have the option to engage in peer-to-peer (P2P) lending using the ISA framework.
The Innovative Finance ISA provides a means for investors and business owners to meet. The latter might also comprise individuals and property developers, but a key segment is the startup market – i.e. founders of early-stage businesses who are seeking funding.
How does it work?
In 2024-25, UK tax residents can contribute up to £20,000 to their ISAs each tax year. This limit applies to the Innovative Finance ISA. So, if an investor wants to, they can commit their full ISA allowance to P2P lending.
When you invest via an Innovative Finance ISA, you are lending money to borrowers upon the promise of repayment – with interest. This differs from investing via a Stocks & Shares ISA, where your money is typically invested in equities and/or bonds.
When invested in an Innovative Finance ISA, your money is not protected by the Financial Services Compensation Scheme (FSCS). This differs from many regular savings accounts and cash ISAs, where the money is protected up to £85,000 if the provider fails.
Pros & Cons
The main attraction of an Innovative Finance ISA is that the interest rates on investments are typically higher than those offered by regular savings accounts and Cash ISAs.
The Innovative Finance ISA can broaden an investor’s access to wider asset classes, such as property and startups – helping with their diversification efforts.
Of course, the tax-free returns available through the ISA structure are also very attractive – letting investors keep more of their hard-earned capital.
There are some important drawbacks, however. Firstly, investors are limited by the £20,000 annual ISA allowance. If you want to invest more in early-stage companies, you will need to consider other/additional options.
Secondly, your capital is at risk when engaging in P2P lending. When giving loans, there is a chance that borrowers may default.
There is also the possibility of wider platform collapse (e.g. due to insufficient contingency funds). The process of withdrawing from an Innovative Finance ISA can be slow, too.
How the IFISA Compares
If you are interested in early-stage investing, the Innovative Finance ISA is not your only option. There are at least three other routes which could be worth considering:
- The Enterprise Investment Scheme (EIS). EIS-qualifying shares can offer investors great tax benefits, such as up-front Income Tax Relief.
- The Seed Enterprise Investment Scheme (SEIS). Offers similar tax benefits to EIS.
- Venture Capital Trusts (VCTs). Attractive to income investors due to tax-free dividends.
These options compare quite favourably next to the Innovative Finance ISA.
For instance, the annual limits are higher. Whilst the IFISA is limited to £20,000 per year, the Enterprise Investment Scheme has an annual investment limit of £1m.
The tax benefits are also more comprehensive. In particular, investments in an IFISA are not exempt from inheritance tax (IHT). However, EIS and SEIS shares are taxed at an effective IHT rate of 20% if they exceed the owner’s tax-free allowances (e.g. the nil rate band).
How to Use the Innovative Finance ISA
When considering the IFISA, it is always important to examine your investment goals, values and wider circumstances first.
For instance, if you are interested in startup investing but do not want to actively “mentor” or manage the businesses you invest in, then responsible P2P lending can be a good option.
The barrier to entry is also lower compared to other early-stage investment routes. Angel investing, for example, requires large sums of up-front capital from investors and a willingness to exchange this for an equity stake. An Innovative Finance ISA allows investors to pool their resources with others with smaller sums.
If you want your investments to concentrate on providing an income, then the IFISA could be useful due to the regular interest payments. However, the annual ISA limit will prevent most investors from earning significant sums.
The Innovative Finance ISA can be helpful for tax planning when building a portfolio. If you are maximising your Personal Savings Allowance, then the ISA “wrapper” can be valuable to shield loan interest payments from tax.
Investors need to weight the opportunity cost of focusing their ISA allowance on the IFISA instead of other assets. Every £1 invested here is £1 that could have been invested in a stocks & shares ISA or a Lifetime ISA. The ideal allocation of this allowance will depend on your unique goals and situation.
If you’d like to explore our early-stage investment opportunities here at our exclusive network, please get in touch.
