10 things you need to know about ISAs

As the ISA season enters its final week, banks and building societies are gathering speed, heavily advertising their ISA products and extolling the virtues of saving in them.

But aside from the competitive rates offered by some providers, what are the advantages of saving in an ISA? Especially when inflation currently has such a damaging impact on our money? Here are 10 things you should know about ISAs before getting one.

1. You earn interest tax-free

The biggest advantage of cash ISAs over other savings accounts is that the interest you earn is tax-free. That means a basic-rate taxpayer would not have to pay tax on the income earned on an ISA as they would have to on a standard savings account, while a higher-rate taxpayer would escape paying 40% on the interest inside an ISA wrapper.

To put into perspective, a savings account with an advertised rate of 3% really only pays 2.4% interest if you’re a basic-rate taxpayer and 1.8% if you’re a higher-rate taxpayer. Higher-rate taxpayers also benefit because they don’t have to pay tax on any dividends they earn in stocks and shares ISAs.

Outside of an ISA they’d have to pay 32.5% dividend tax, but within an ISA they have nothing to pay, bar the initial 10% tax deducted. Basic-rate taxpayers, however, pay the same 10% rate in or out of the ISA.

2. There are big incentives to leave your money in an ISA

With some savings accounts it’s so easy to access the money you wouldn’t think twice about cracking open your savings. However, taking your money out of an ISA would see your money lose its tax-free status, therefore encouraging you to leave it put.

Even if you cannot save anywhere near the full amount into an ISA, just saving £100 a month into an ISA for 10 years would be worth £12,527 in a cash ISA, according to Fidelity Worldwide Investment, or a significantly higher £16,386 in a stocks and shares ISA (Fidelity’s calculations are based on average interest rates for cash ISAs versus the average performance of the FTSE 100 All Share index over 10 years).

Leaving your money be for the long term certainly makes sense.

3. The annual deposit limit goes up in line with inflation

The current ISA limit for 2011/12 is £5,340 for a cash ISA or £10,680 in a stocks and shares ISA, minus anything you put in a cash ISA. These limits will increase in April (tax year 2012/13) to £5,640 and £11,280 respectively.

4. Annual ISA limits don’t roll over

If you don’t save the full amount into an ISA each tax year, you won’t be able to roll it over into the next tax year - so you should use up as much of your allowance as you can. On top of that, if you withdraw some money from your ISA, that part of your allowance is still counted as used.

5. Transfer to a better rate

Apart from long-term fixed-rate ISAs, with cash ISAs the headline interest rates tend to only last a year, after which interest rates drop dramatically to a nominal 0.1% or thereabouts.

That means transferring to another ISA is essential if you want to keep earning interest. Thankfully, the process has sped up, now taking only 15 days, and providers will handle the process for you. Bear in mind though that not all ISAs accept transfers.

6. They are flexible

Thanks to their flexibility, many savers are using ISAs to save for their retirement years, supplementing their pension savings. Employer contributions into a pension are a considerable advantage but the drawback of pensions is that you can’t access your money until you are at least 55 and even then not all in one go.

With an ISA, you have the opportunity to build up additional sums and access them when you want. Because you’ve already been taxed on your income, you’re not taxed again when you withdraw money from an ISA - so you know exactly how much money is in your pot.

Whereas, because pensions grow from your gross (pretaxed) income, you will have to pay tax on your pension when you withdraw it. Paul Kennedy, head of tax planning at Fidelity FundsNetwork, says both have pros and cons.

“It is probably best not to look at one method being more advantageous than the other but simply accept that these are two ways of saving for the future.”

7. Large investment choice

Stocks and shares ISAs give investors the chance to invest in a variety of assets from funds, investment trusts and fixed income options, such as corporate and government bonds, to individual shares if you are picking your own portfolio in a self-select ISA.

8. Avoid capital gains tax

Any income you gain from your investments isn’t liable for capital gains tax (CGT), which is charged at 18% standard rate and 28% higher rate. Outside of an ISA, any gains from a sold asset are subject to CGT (your overall gains must be over the £10,600 threshold to be liable) but within an ISA you don’t have to pay any capital gains.

9. You don't have to declare ISA earnings to the taxman

You don’t even have to inform your tax office that you have an ISA, let alone show HM Revenue & Customs how much income or capital gains you’ve made from a stocks and shares ISA because they are tax-free. That’s one less thing to worry about when filling in your tax return.

10. Bed ISA

If you’ve already got shares and funds outside an ISA wrapper, you can use a process called ‘bed and ISA’. The point of doing this is you can move investments into a tax-free environment. This allows you to sell existing investments and then re-buy them in an ISA wrapper. So before taking the plunge, it’s advisable to speak to an IFA.

Kennedy warns that there could be charges to consider and that investors need to understand that they may be out of the market for a few days while the process takes place.