Back to basics guide to ISAs
An Individual Savings Account (ISA) is a tax-efficient way to save, with no tax liability when you withdraw the proceeds. Your investment will roll up free of capital gains tax. Share dividends suffer with a 10% income tax deduction, but there is no income tax on cash held within the cash element or on fixed interest from bonds.
An ISA is not an investment in itself but a wrapper to shield your investment from tax - whether it is cash, bonds or equities. The tax breaks are on exit, not entry. So you invest using taxed income, but the proceeds on withdrawal are tax free.
However, the 10% tax credit on dividends was abolished a few years ago, so ISAs are not as tax efficient as they used to be for basic rate taxpayers, but they remain beneficial for higher rate taxpayers, or for anyone who thinks they may become a higher rate tax payer in the future.
They can also be used as part of a long-term financial planning strategy. For example, you can transfer ISA savings into a pension at any time, thereby exploiting the generous tax reliefs on pension contributions.
Unit trusts and OEICs can usually be bought more cheaply within an ISA wrapper as fund management groups often offer discounts on initial charges, particularly in the run-up to the end of the tax year in the period between January and March.
Mini and maxi ISAs
The new ISA rules effective from 2009 are as follows:
From October 2009 the over 50’s can invest up £10,200 in Investment ISAs or £5,100 in Cash ISAs. This new limit will be applied to all ISA savers for tax year 2010-2011.
After 6 April 2008, the rules governing PEPs and ISAs are as follows:
- Existing PEP and TESSA only ISA (TOISA) accounts will be re-designated as stocks and shares, and cash ISAs, respectively;
- The distinction between mini and maxi ISAs is abolished, with accounts being re-designated as "cash accounts" and "stocks and shares accounts;"
- You can convert cash ISAs into stocks and share ISAs and this will not count against the prevailing year's ISA allowance (but you can't do the reverse);
- Money held in child trust fund (CTF) accounts can be rolled over into an ISA once a child reaches 18.
Cash and equities
The investment rules mean you can invest £3,600 in a cash ISA and £3,600 in an equity (or stocks and shares) ISA, or the whole £7,200 in an equity ISA.
Cash ISAs include bank and building society deposits, and money market unit trusts. Some National Savings products are also included, as well as a range of existing bonds and accounts on which tax is normally payable.
A stocks and shares ISA can include any authorised unit or investment trust, or open ended investment company (OEIC), as well as any share quoted on a stock exchange recognised by the HM Revenue & Customs.
So, what's best, cash or equities? That depends on your attitude to risk and whether you are investing for the short or long term. Equities have the potential for higher returns over the long term and there is the opportunity for growth both in capital and income.
Shares are more risky although risk can be spread by investing in diverse portfolio of shares or via unit and investment trusts.
Cash, on the other hand, is more secure if you cannot afford to lose your initial capital and would be worried by stock market volatility. It also gives you access to your money at short notice, although remember that some cash ISAs pay higher interest in return for giving notice which, in some cases, is as much as one year..
Most banks and building societies offer cash ISAs, but the terms and conditions vary considerably. Some accounts require a minimum deposit when you open the account, while others can be opened with just £1.
Some allow instant access, while others have a notice period for penalty-free withdrawals. Some allow transfers-in from other cash ISAs, while others do not. Some ISAs can only be managed online.
Rates offered on cash ISAs are often higher than on the same institution's standard savings accounts, so this, together with their tax free status, make cash ISAs a no-brainer for most investors.
Stocks and share ISAs (also known as equity ISAs) are sold by stockbrokers, IFAs, fund managers, banks and other authorised financial institutions. You can buy ISAs directly with these institutions or you can take advice from an independent financial adviser on where to invest.
If you want to invest in individual shares and choose your own funds, a 'self-select' ISA may suit you. Unit trusts, OEICs and exchange traded funds (ETFs) are the most commonly used investment for stocks and shares ISAs.
How much do ISAs cost and where can I buy them?
How much an equity ISA costs depends on where you buy it and what you invest in. The vast majority of ISAs come with initial and annual management charges.
The initial charge on investment funds placed within an ISA can range from 2.5 - 5%, although many firms offer discounts of 2-3% off initial charges.
The annual management charge is typically between 0.5% and 2%, depending on the type of fund you invest in.
You can buy ISAs direct from fund managers, which manage collective investment funds such as unit trusts, open-ended investment companies (OEICs) and investment trusts. However, this is not a cost effective way of buying as you will pay the full initial charge, whereas by buying from an IFA, you should get a discount.
Buying through an IFA can be a good idea as you will get advice and most advisers will rebate some of their commission so that the initial charge is reduced from 5-6% to 2- 3%.
You can also buy via 'discount brokers' and 'fund supermarkets' which also give generous discounts. In some cases, you may not have to pay any initial charge at all.
For example, if you invest £7,200 and get a 5% rebate, you will save £360 in costs.
Stocks & Shares ISA
Last Edited February 2010
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