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ISAs: The basics
By Sarah Coles
It's almost a decade since individual savings accounts (ISAs) were introduced in the UK and, in that time, 17 million Britons have saved about £220 billion in them. However, millions more have intended to save but have been discouraged by the host of seemingly complex rules and difficult choices.
This is a real shame, because the tax breaks mean that ISAs should be a vital part of every savings and investment strategy. They can be used like a cash savings account, if you're saving for a big event or big purchase months or years down the line. Or they can be used when you're investing in shares or unit trusts, to make your investments more tax-efficient.
ISAs were introduced in 1999 to replace the previous range of tax-efficient savings vehicles; the whole point of their existence is to save you paying more tax than you need to. Any money saved inside an ISA is not subject to either income or capital gains tax.
And once you get beyond the jargon, ISAs are relatively easy to get to grips with.
Cash or equities?There are broadly two types of ISA: cash ISAs, and stocks and shares ISAs (also known as equity ISAs). The cash ISA is by far the most popular, but you can invest more in stocks and shares ISAs and, if your investments perform well, shelter far more of your hard-earned cash from the taxman.
Cash ISAs are essentially just savings accounts, where any interest is paid tax-free. This means they are suited to lower-risk investors who want the guarantee that their savings will not reduce in value.
Like savings accounts, however, they come in many shapes and sizes. While some offer great interest rates, others are lousy, and while some let you have instant access to your money, others require you to tie it up for a year or more. So you'll need to scour the market first.
Stocks and shares ISAs, meanwhile, allow you to invest across a far wider range of investments, including shares, corporate bonds and gilts.
The most common - and most straightforward - form of equity ISA is one that invests in collective investments, where your money is pooled with that of thousands of other investors and invested in the stockmarket on your behalf by the fund manager.
This collective investment may be a unit trust, an open-ended investment company (which is essentially the same thing with a slightly different legal stucture) or an investment trust. You may not be aware of the technical name of an investment, but wherever someone talks about a 'fund', this is what they're referring to.
Up until 2004 there was a further tax benefit on collective investments like these, because fund managers could reclaim the tax they had to pay on dividends. New rules introduced in April 2004 put an end to this tax break. For higher-rate taxpayers there is still a tax saving, but for basic rate taxpayers the tax on dividends is the same inside an ISA as it would be outside. However, stocks and shares ISAs still benefit from the fact they are free from capital gains tax.
More control?Alternatively, if you would like more control over your investments you can opt for a self-select stocks and shares ISA, which allows you to buy and sell shares directly, making them ideal for those who trade on a regular basis.
Whether you opt for a cash or stocks and shares ISA, it's worth knowing that the Government has identified certain potential characteristics which allow a product to brand itself as a stakeholder.
For a cash ISA, this means there are no charges; the minimum deposit is £10 or less; the interest rate will never fall more than 1% lower than the Bank of England interest rate; you can make unlimited withdrawals; any notice period will be no longer than seven days; and you can pay into your account using cash, cheques, standing orders or BACS.
For a stocks and shares ISA, there are two types of stakeholder, a 'smoothed' one and a 'non-smoothed' one. They have some rules in common: a minimum investment of £20; the charges are capped at 1.5% a year for the first 10 years and 1% thereafter; and no more than 60% of the investment can be in shares.
The smoothed account has other rules, requiring money to be paid in to top up the return in bad years - much like a with-profits account. They are suitable for some investors, but are fairly restrictive, and the smoothing concept is somewhat outdated - so the stakeholder label is by no means an endorsement.
A stakeholder will not necessarily be the most competitive or best-performing ISA, but at least it provides a set of minimum standards and highlights key features to look out for when you shop around.
How much can I invest?In this tax year you can invest a total of £7,000 in ISAs, but exactly how will vary according to whether you want to invest in cash, equities or both, and whether you invest in a mini or maxi ISA.
At the moment, you have a choice of investing in either two mini ISAs in any one tax year or one maxi ISA. If you opt for minis, you can invest up to £3,000 in a cash mini ISA with one provider and up to £4,000 in a mini stocks and shares ISA with another. Alternatively, you can plump for a maxi ISA in which you can hold your entire £7,000 allowance with one company. You can then either invest the full £7,000 in stocks and shares or up to £3,000 in cash, with the remainder in stocks and shares.
You can access your money once it's invested, but if you invest up to the limit, you cannot top it up again until the start of the next tax year, when you get a fresh allowance.
These complicated rules are due to be simplified in the next tax year - the investment limits are changing and the confusing mini or maxi distinction will disappear.
From 6 April 2008 there will be an overall limit of £7,200. You can invest up to £3,600 in a cash ISA, and the remainder in a stocks and shares ISA. This means if you put the full £3,600 in cash you can put a maximum of £3,600 in stocks and shares. If you put £1,000 in cash, on the other hand, you can put £6,200 in stocks and shares. And if you don't use the cash portion at all you can invest the lot in stocks and shares.
Other changes will apply to existing tax-efficient savings. People who hold Personal Equity Plans (PEPs) will have them renamed as ISAs to make managing their portfolio easier. In addition, people who hold cash ISAs will be able to transfer them into stocks and shares ISAs, without affecting their allowance for this year. They cannot, unfortunately, transfer them the other way around, because this move was designed to encourage further investment in stocks and shares.
Although these rules don't come into force until April, don't let that put you off investing in the meantime. If you leave your ISA decision until then, you'll miss out on £7,000 worth of tax-free investing.
Now that you know the rules and the limits, the next step is to identify the kind of ISA that suits you, and the provider offering the right kind of product for you. The rest of this guide will help you through these steps so you can find the best ISA for 2008.
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