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ISAs: back-to-basics By Sam Barrett
ISAs were introduced in April 1999 as the Labour Government's successor to personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs). Not investments in their own right, ISAs are wrappers that can be placed In spite of the new name and several rule changes, the fundamental benefit of this investment vehicle has remained the same - tax-efficiency. Anything you place inside an ISA wrapper is exempt from income and capital gains tax. Growth of investments inside an ISA is also tax-free, although the changes to taxation of company earnings in 2004 slightly diminished this benefit for ISAs investing in stocks and shares. From April 2004, fund managers were unable to reclaim the 10% tax credit on dividends. For higher-rate taxpayers there is still a tax saving but, with the loss of the tax credit, basic rate taxpayers pay exactly the same tax on dividends as they would have if they'd held the investment outside the ISA wrapper. Although this has taken some of the shine off ISAs, they still offer significant tax advantages. In particular, interest on cash is received gross and any investments are exempt from capital gains tax. Even if you're not a taxpayer or are worried about capital gains tax, you should consider an ISA. Your circumstances may change, making previous years' ISAs an invaluable tax shelter for your money. The different types There are two types of ISA - the cash ISA, and the stocks and shares ISA. The most popular option, cash ISAs are offered by banks and building societies and are essentially tax-free savings accounts. Interest is paid regularly, so your money is guaranteed not to reduce in value. As with ordinary savings accounts, rates vary substantially. While there are plenty of great deals available, there are also lots paying dismal rates of interest. The accounts also share many of the features of standard savings accounts, including bonuses, fixed rates, notice periods and penalties. As a result, you need to think about how much access you'll need to your money, before making your choice. The other type of ISA is the stocks and shares ISA. These can invest in a wide range of assets, including authorised unit trusts and open-ended investment companies (OEICs), investment trusts, gilts (providing they have a term of at least five years remaining) and shares. Unlike their predecessors, PEPs, there are no geographical restrictions on where you can invest. The most common form of stocks and shares ISA is one that invests in a collective investment such as a unit trust or investment trust. With these you benefit from diversification, as well as the expertise of a fund manager, who will make investment decisions on your behalf. Alternatively, if you prefer more control over your investments, you could choose a self-select stocks and shares ISA. These allow you to pick the shares you want to invest in and when you want to invest in them, making them ideal for those buying shares on a regular basis. You should also be aware of stakeholder ISAs. An ISA gains the stakeholder product label if it meets certain conditions set by the Government. For cash ISAs, there must be no charges, the minimum deposit must be £10 or lower, and you should be able to pay into your account by cash, cheque, direct debit, standing order or BACS. Also, the interest rate must never be more than 1% below the base rate and you must be able to make unlimited withdrawals, with the money available within seven days. For stocks and shares ISAs, two stakeholder products apply - the medium-term investment product and the smoothed medium-term investment product (which works in a similar way to with-profits to smooth out returns). These products also need to meet certain criteria, including a minimum investment of £20 or less, an annual charge of 1.5% or less for the first 10 years, with a charge of 1% thereafter. Most importantly for cautious investors, no more than 60% of the fund can be invested in shares. How much you can invest You can invest up to £7,000 into ISAs every tax year. Withdrawals are permitted, but once you've taken the money out of your ISA you cannot replace it unless you still have some allowance remaining. However, exactly how you invest this money is being simplified. New rules announced by the treasury minister, Ed Balls, in November last year (and expected to come into force in April next year) should make it much easier to invest in ISAs. Under the original rules, you could either invest the full £7,000 into a stocks and shares ISA or you could split your investment, placing up to £3,000 into a cash ISA and £4,000 into a stocks and shares ISA. You would also have to choose carefully between the two different types of ISA - the maxi and the mini - as you cannot invest in both types in any tax year. If you plumped for a maxi ISA you would have to hold all that year's ISA investments with one company, either as up to £3,000 in cash and the remainder in stocks and shares, or as up to the full £7,000 in stocks and shares. Mini ISAs allowed you to hold your cash ISA with one company, up to the £3,000 limit, and your stocks and shares ISA with another, up to the £4,000 limit. The new rules will do away with the mini and maxi distinction and there will simply be a £7,000 maximum a year, with investments into cash ISAs subject to a maximum of £3,000 a year. Existing PEPs will also be renamed as ISAs, making it easier to manage an investment portfolio. The other important change is the ability to transfer money held in cash ISAs into stocks and shares ISAs. This will allow you to start your savings in a cash ISA, if you don't want to risk them on the stockmarket, and then roll them over into stocks and shares ISAs when you've built up a larger fund and are happy to take the risk. Unfortunately, however, this won't work the other way round, although the ability to switch out of equities and into cash would be useful for older investors looking to reduce the risk of their portfolio in retirement. As well as announcing that ISAs were here to stay beyond their initial 10-year term, Balls also hinted that the annual contribution allowance might be raised. Although there are no concrete figures yet, many expect it to be raised to £9,000. But even with the £7,000 cap, the benefits of ISAs are too good to ignore, so make the most of this year's allowance before you lose it. The benefits of regular saving If you had taken advantage of your full allowances since ISAs were introduced in 1999 you could have squirreled away a sizeable amount of money. Assuming you put the full £3,000 into a cash ISA each year, you would have saved £24,000 by now. If this achieved an average interest rate of 5%, it would be worth more than £30,000 at the end of this tax year. With the remaining £4,000 going into a stocks and shares ISA, this would have amounted to a total investment of £32,000. Assuming this went into the average ISA fund, this amount would have grown to £47,675 by the end of 2006, according to figures from Lipper. If you had invested the full £7,000 into the stockmarket, making a total investment of £56,000, this would have been worth £83,432 at the end of 2006. The new ISA rules at a glance The new rules will simplify the system, making it easier to understand what you can, and can't, do with your ISA. It is expected that these rules will be introduced in April 2008.
The mini and maxi ISA distinction will be scrapped - ISAs will simply be cash or stocks and shares. A £7,000 a year overall limit will apply. Up to £3,000 of this can be invested in cash, with any remainder available for stocks and shares investments. Investors will be able to transfer money held in a cash ISA into a stocks and shares ISA. Existing PEPs will be renamed as stocks and shares ISAs. Going forward, 18-year-olds will be able to roll their child trust funds into an ISA if they want to continue enjoying tax-free growth.
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