Build a tax-efficient portfolio

If your ambitions for 2010 are to make sure your investments are working at their optimum level, then the first step is to ensure there is little or no tax being siphoned off by Alistair Darling.

Likewise, if one of your resolutions is to start an investment portfolio (perhaps because you're fed up with the anaemic interest rates on cash) then this feature should help you get all the building blocks in place to turn.

A stocks and shares ISA is the most tax-efficient way of investing. You can put £7,200 in each tax year, athough people aged over 50s can put in £10,200. The allowance will rise to £10,200 for everyone at the start of the next tax year.

However, if you choose to put any of that (up to half) into a cash ISA, the corresponding amount will be deducted from your stocks and shares ISA allowance.

One of the main differences to a cash ISA is that it's a long-term vehicle - you should tie your money up for at least three to five years to give your investments a decent chance of growing.

It's a wrap

Before we turn to the actual investments and the question of tax, how do you go about picking the ISA wrapper itself?

"The type of ISA provider chosen will be dependent upon whether an investor wishes to appoint a professional fund manager or simply needs a conduit through which they wish to buy and manage their own investments," points out Chris Cole, senior wealth adviser at Towry Law.

If you are happy to have your ISA invested in funds from just one firm or in one investment trust, then you can go direct to that provider. For example, Witan offers an ISA that is basically a wrapper around its investment trust.

Similarly, Rathbones offers an ISA, allowing you to invest in its unit trusts. Structured product providers also normally offer an ISA wrapper.

However, if you wish to make your portfolio more diversified then the increasingly popular self-select ISA may be more suitable.

"It used to be the case that you bought your ISA from an individual fund manager," says Martin Bamford, managing director of financial planners Informed Choice.

"'The usual route today, however, is to use a fund supermarket where you can access a very large number of funds from a variety of fund managers. This means you do not need to change the ISA wrapper in the future in order to switch to a different fund manager."

He adds: "Fund supermarkets usually come with a cost advantage, certainly in terms of switching between funds, which is typically charged at 0.25% of the amount switched rather than the usual fund initial charges."

Rebecca O'Keeffe, head of investment at Interactive Investor, says the main difference between wrappers is the cost of administration, so you should check this carefully according to what sort of investments you expect to be buying.

This is another difference with cash ISAs: there are fees to pay. These are often just the same as buying the investments on their own; for example Interactive Investor doesn't charge a wrapper fee, but you do have to pay the funds' underlying charges. If you buy shares, you will also have to pay stamp duty.

"Some ISA accounts have an annual account fee in addition to the annual management charge for funds, but this is typically only for those accounts that offer access to investments in company shares," observes Bamford.

In terms of investments, pretty much anything goes: open-ended investment companies (OEICS), unit trusts, investment trusts, exchange traded funds, shares, gilts (with at least five years until they mature) and corporate bonds. Aim shares are barred, however.

If you're unsure how to invest your ISA, then it's worth talking to a financial adviser first. Speaking to them about your other financial planning goals at the same time will ensure a more cost-effective visit.

Hannah Edwards, a financial planner at Killik & Co, explains that an advisory broker or financial planner can advise on the most appropriate strategy or even manage the funds on the investor's behalf.

"Having a conversation before you make your final decision may be invaluable in establishing the most tailored ISA portfolio for your risk appetite and investment goals," she comments.

Risk tolerance

Geoff Tresman, chairman of Punter Southall Financial Management, gives some broad advice for asset allocation: "Your attitude to risk will determine how much of the ISA you are prepared to commit to equities and how much to more defensive asset classes such as bonds and gilts.

"A higher tolerance for risk translates into a higher exposure to equities, as does a longer investment time-frame.

"If you feel you may require funds over a shorter period of time, for example up to five years, or your attitude to risk is fairly cautious, then having a higher proportion of money invested in corporate bonds and gilts would be advisable."

There are still a few months left before the end of the tax year, so there's still time to think about where to invest your 2009-2010 allowance.

As a fallback option you can always put some money into a cash fund 'pending investment'; for example, Fidelity FundsNetwork offers a 'Cash Park' for this very purpose.

However, it will incur a 20% tax charge on the interest, and your ISA provider will write to you regularly (as dictated by HM Revenue & Customs) encouraging you to reinvest.

If you are managing your own investments in a self-select ISA, you need to remember to review it.

Common sense

Colin Jackson, director at Baronworth Investment Services, has a common sense approach: "If it's an ISA with OEICS or shares in it, then review it when you get statements, say every six months.

"Many people, when they set up investments, like to check them every day, but you should resist doing it that frequently."

So what about this 'tax-free' tag? Surely nothing's free from Darling's reach?

"ISAs are very tax-efficient. You don't pay income or capital gains tax [CGT] and you don't have to declare them on your tax form," Jackson explains.

Different investments trigger income tax and CGT. As we all have an annual £10,100 CGT allowance, Jackson recommends that if you don't have room in your ISA for both your CGT-generating investments and your income tax-generating investments, you should put the latter in.

"That way, your ISA will be more efficient at saving you tax and the CGT-liable investment should be covered by your CGT allowance," he says.

ISAs are also of more use to higher- rate taxpayers, as you'll save 40% income tax rather than 20%.

However, as with everything in life, there is a bit of small print. First, the 20% tax charge on cash awaiting investment. Second, there is a 10% tax credit on UK dividend income that cannot be reclaimed by ISA fund managers.

And, finally, if your ISA assets form part of your estate on your death, it could be subject to inheritance tax.

You can open an ISA with either a lump sum or by pledging to pay in a fixed amount each month.

For those that are just starting to save and have smaller amounts to invest, Cole points out that monthly contributions can benefit from pound-cost averaging.

This means that as you drip-feed money in on a regular basis you should see potentially smoother investment returns over the long term, and you can buy more units when markets are lower and avoid buying too many at the top end of the range.

Some final tips

Remember that when you set up your new ISA, you could transfer any existing 'non-ISA-wrapped' investments into it.

"This is great to do for general tax management purposes, but is also useful if you can't afford to put a lump sum in your ISA or don't want any more market exposure," observes O'Keeffe.

You should also avoid cashing in your ISA, as you would then lose the tax-free wrapper. You should just transfer it.

If you're still unsure about the merits of starting off your first stocks and shares ISA, Jackson has some final words about how an ISA could potentially prove more useful than a pension.

He thinks ISAs are better than pensions as they are more flexible. "The government won't even know you've got an ISA, as it's not declared on your tax return and there's no tax-free lump sum, annuity or complicated government rules to deal with," he says.

Cash ISAs

It's more straightforward to choose and open a cash ISA than it is a stocks and shares ISA, but there are still some issues to consider.

As you'd expect, a cash ISA works just like a savings account, only it's tax-free so you don't pay income tax on your interest. And just like a savings account, they also come in different shapes and sizes.

There are fixed or variable rates, some restrict withdrawals, some are only accessible by telephone or internet, and they all offer different interest rates.


As the recession bites, banks and building societies are offering headline-grabbing savings rates to help build their reserves, but to new savers only. So even if they are advertising rates of 3%, their loyal savers may be wallowing in accounts that pay less than 0.5%.

Your cash ISA provider won't tell you when the interest rate falls so savers should be prepared to check their rate and switch.


Naturally, higher returns are available for fixed-rate deposits, which involves locking your money up for between one and five years.

Keep a watchful eye

"Banks and building societies hook us in on a market-busting rate, as they know the apathetic streak in many of us will result in us not actively shopping around and switching providers every 12 months. With cash ISAs however, one may need to take an active approach," explains Edwards.

According to Cole, savers should also try and look for consistent providers rather than top rates. "Too often, we have seen cash ISA providers launch with a good rate only to see it drop sharply once you have invested.

"A provider with a consistent approach would be better than one who is providing the highest rate initially."

In addition to interest rates, Bamford says the Financial Services Compensation Scheme (FSCS) should not be forgotten.

"You need to think about the financial strength of the bank, particularly if you have other savings with the same institution that would take you over the £50,000 limit," he advises.

Despite painfully low interest rates in the UK and no sign of a rate rise, experts concur that cash ISAs still have merits.

"For individuals looking for complete capital preservation, a cash ISA remains the most appropriate environment, especially if you need the funds back in less than five years," says Edwards.

Tresman sums up: "With the base rate at 0.5%, people may think that having ISAs invested in cash is not sensible, but some of the fixed-rate returns available, which exceed 3.5% to 4%, guarantee a real rate of return above the rate of inflation."

This article was originally published in Money Observer - Moneywise's sister publication - in January 2010

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