Back-to-basics guide to ISAs
Whether you want to put away some spare cash for a rainy day or you'd like to invest for the future, an individual savings account (ISA) is worth considering.
Introduced in 1999 to replace Peps and Tessas, ISAs offer a wide range of options when it comes to saving and investing.
First up is the cash ISA. These operate like savings accounts, allowing you to earn interest on your deposit. They're offered by banks, building societies and other financial institutions and are available to anyone aged 16 or over.
Just like standard savings accounts there are a number of different features available, including fixed rates, instant access, regular savings, notice accounts and bonuses. They are also available through a high street branch, by post or online.
2. STOCKS AND SHARES ISA
The other type of ISA invests in stocks and shares. This is available for anyone aged 18 or over and can either be through a fund – for instance, a unit trust or open-ended investment company – or directly into stocks and shares.
Where you look to invest directly you can pick from investments including shares, with a huge range of UK and international companies eligible; corporate bonds and gilts (government bonds); investment trust; and exchange traded funds.
WHAT ARE THE TAX BREAKS?
For both cash and stocks and shares ISAs, the key advantage is their tax status. On a cash ISA, interest is tax-free.
So, if a cash ISA is paying 3% interest, a basic-rate taxpayer would need to find a taxed savings account with an interest rate of 3.75% to receive the same level of interest after tax. For a higher-rate taxpayer, the interest rate on the taxed account would need to be 5%.
With stocks and shares ISAs the rules are slightly different. For dividend income, a tax credit of 10% is taken before it is paid to you and this cannot be reclaimed.
Therefore, for basic-rate taxpayers, there is no difference between what they would receive if they held investments within or outside an ISA wrapper.
Higher-rate taxpayers do see an advantage, though, as they would normally pay 32.5% tax on dividend income. So, although they still have to forfeit the 10% tax credit, it saves them paying a further 22.5% on the gross dividend.
In financial terms this means that if they receive a dividend of £90, which would have been £100 gross with the 10% tax credit, they would have to pay a further £22.50 in tax if the investment was held outside an ISA, but nothing more if it was held within an ISA.
An exception to this is with fixed-interest investments such as corporate bonds and gilts. As the income is derived from interest rather than from dividends, it's tax-free in exactly the same way as interest from a cash ISA.
The other tax break with stocks and shares ISAs is that they aren't subject to capital gains tax (CGT). This tax is payable when you sell certain assets, including shares, and the gains you have made exceed the annual allowance (£10,200 in 2009/10).
If your profits do exceed the allowance then you pay CGT at 18% on the excess for any investments held outside an ISA wrapper.
With these tax breaks on offer, there are limits on the amount you can save into ISAs each tax year. At the moment, it's £7,200 and out of that, up to £3,600 can be put into a cash ISA.
It's also perfectly acceptable to ignore the cash element and put the full amount into a stocks and shares ISA.
For anyone who will be 50 or over by 5 April, the current annual limit is £10,200. Of this, up to £5,100 can be put into a cash ISA, with the balance going into a stocks and shares ISA – this higher limit will be available to everybody from 6 April this year.
However, you can only use your ISA allowance once. So, if you put £3,600 into a cash ISA and then withdraw £500 to pay an unexpected bill, you can't then replace this withdrawal with a further £500.
Another deposit rule you need to be aware of when investing in ISAs is that you can only open one cash and one stocks and shares ISA each tax year.
You can, and probably will, pick different providers for your cash and stocks and shares ISAs, but if you've already opened a cash ISA this tax year you can't open a second cash ISA with another provider until next tax year.
This isn't as restrictive as it might sound. With cash ISAs you're likely to be looking for the best rate, so there's no need to spread your money between providers.
Likewise, with stocks and shares ISAs, fund supermarkets allow you to build up a portfolio of funds from different providers within the same ISA so there's no need to be tied to just one fund manager.
It's also possible to move your ISAs around if new opportunities present themselves or you're not happy with your choices.
As well as being able to move your old cash and stocks and shares ISAs into new ones, you can also move old cash ISAs into stocks and shares ISAs.
If you do decide to move, it's important to be aware of the rules. HM Revenue & Customs allows you to move some or all of previous tax years' ISAs.
Most importantly, though, don't withdraw the money and take it to your new provider. If you do this you will lose your tax-free allowance.
Instead, go to your new provider and it will ask you to complete a transfer request form, which enables it to do all the legwork on your behalf.
The events of the last few years in the banking arena also mean that the security of your savings and investments are an important consideration.
Cash ISAs are covered by the Financial Services Compensation Scheme (FSCS) deposit protection scheme. As such, if your ISA provider becomes insolvent, the first £50,000 of your money is protected (or first £100,000 if you have a joint account).
Be careful, though. As the FSCS limit applies to all deposits with the same financial institution, check if you have other savings with your ISA provider as you might breach this limit and risk losing money if something happens.
Stocks and shares ISAs fall under the FSCS investment protection scheme. In the event of default, it would pay 100% of the first £50,000 invested.
Previously the scheme paid a maximum of £48,000 - 100% of the first £30,000 and 90% of the next £20,000 you had invested.
Adopting a regular savings habit is a good way to take advantage of the individual savings account allowance without feeling the pain of making a last-minute investment at the end of the tax year.
And, if you had got the regular savings bug when ISAs were introduced in April 1999 you would be sitting on a comfortable nest egg by now.
Figures from Moneyfacts show that if you'd taken advantage of your full cash ISA allowance each year you'd have invested £34,200, which would now be worth £36,016.
Meanwhile, for stocks and shares ISAs, if you'd invested a regular monthly amount (£586.33 until April 2008, then £600 a month) at the end of 2009 your £75,600 would now be worth, on average, £114,046.67, according to figures from Lipper.
Investing regularly into a stocks and shares ISA enables you to benefit from pound-cost averaging where you benefit from being able to buy more shares when the stockmarket is down and less when it's higher, which creates a smoothing effect.
For example, say you invest £500 each month into a unit trust. The first month the price is £1 and you buy 500 units. The second month the price has fallen to 80p and you are able to buy 625 units. In the third month the share price rises a little to 90p.
This means you can buy 555 units (costing £499.50), giving you a total of 1,680 units, worth £1,512. In comparison, if you'd invested £1,500 at the outset, it would now be worth £1,350.
AT A GLANCE
Follow the ISA rules and you can enjoy tax breaks on your savings and investments. Our at-a-glance guide will help you make the most of your allowances:
* The annual ISA allowance is £7,200. Of this, up to £3,600 can be invested in a cash ISA with the balance, up to the total £7,200, available for a stocks and shares ISA.
* If you're over 50, your ISA allowance is £10,200 – out of which £5,200 can be invested in cash. This limit will be available to everybody from 6 April when the next tax year starts.
* You can only open one cash ISA and one stocks and shares ISA each tax year.
* If you take money out of your ISA you will lose that part of your ISA allowance.
* You can transfer all or part of previous tax years' ISAs to a new provider.
* You must be at least 16 to open a cash ISA and 18 to open a stocks and shares ISA.
There are limits to how much you can invest in any tax year. For 2011/12, the limit is £10,680. Of that, the maximum you can invest in cash is £5,340 and the balance of £5,340 can be invested in shares (individual company shares or investment funds). If you don’t take the cash ISA allowance, you can invest up to £10,680 into a stocks and shares ISA.
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
A collective investment vehicle (known in the US as a “mutual” or “pooled” fund) and similar to an Oeic and investment trust in that it manages financial securities on behalf of small investors who, by investing, pool their resources giving combined benefits of diversification and economies of scale. Investors buy “units” in the fund that have a proportional exposure to all the assets in the fund, and are bought and sold from the fund manager. The price of units is determined by the value of the assets in the fund and will rise or fall in line with the value of those assets. Like Oeics (but unlike investment trusts) unit trusts and are “open ended” funds, meaning that the size of each fund can vary according to supply and demand of the units form investors. Unit trusts have two prices; the higher “offer” price you pay to invest and the “bid” price, which is the lower price you receive when you sell. The difference between the two prices is commonly known as the bid/offer spread.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
This is more usually a feature of car insurance but it can also crop up in contents, mobile phone and pet insurance policies. An excess is the amount of money you have to pay before the insurance company starts paying out. The excess makes up the first part of a claim, so if your excess is £100 and your claim is for £500, you would pay the first £100 and the insurer the remaining £400. Many online insures let you set your own excess, but the lower the excess, the more expensive the premium will be.
The Financial Services Compensation Scheme is the compensation fund of last resort for customers of authorised financial services firms. If a firm becomes insolvent or ceases trading, the FSCS may be able to pay compensation to its customers. Limits apply to how much compensation the FSCS is able to pay, and those limits vary between different types of financial products. However, to qualify for compensation, the firm you were dealing with must be authorised by the Financial Services Authority (FSA).
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.