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.
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.
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.
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
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.
The tax levied on the total value of your estate after you die. IHT has to be paid by the beneficiaries of your estate before they can receive any of the money from it. The money can’t be taken from the value of the estate _– it has to be paid before any money can be released. There is an IHT threshold – known as the “nil-rate band” – below which no tax is levied (£325,000 in 2011/12). Any amount above the nil-rate band is subject to tax at 40%. If your estate totals £600,000, there is no tax on the first £325,000; however your estate will pay 40% tax on the remaining £275,000, a total of £110,000. Prudent tax planning can reduce your IHT liability, so always consult a specialist solicitor.
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.
Open-ended investment companies are hybrid investment funds that have some of the features of an investment trust and some of a unit trust. Like an investment trust, an Oeic issues shares but, unlike an investment trust which has a fixed number of shares in issue, like a unit trust, the fund manager of an Oeic can create and redeem (buy back and cancel) shares subject to demand, so new shares are created for investors who want to buy and the Oeic buys back shares from investors who want to sell. Also, Oeic pricing is easier to understand than unit trusts as Oeics only have one price to buy or sell (unit trusts have one price to buy the unit and another lower price when selling it back to the fund).
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.
Sometimes known as a trading ISA, a self-select ISA gives investors full control over which assets to include in their ISA, allowing them to choose individual shares and bonds rather than investment funds. Aimed mainly at experienced investors and subject to the same investment limits of a regular ISA, a self-select ISA will usually be managed by a stockbroker on an investor’s behalf.
Tax-free lump sum
An inelegant phrase that is nonetheless accurate in what it describes: a one-off payment to a beneficiary that is free of any form of taxation. Usually received when using a pension fund to purchase an annuity, as 25% of the overall fund can be taken as a tax-free lump sum.
A hugely unpopular tax paid on property and share purchases. Stamp duty on property is levied at 1% for purchases over £125,000 (£250,000 for first-time buyers) which then moves up at a tiered rate. For property between £125k and £250k you pay 1%, then 3% from £250k up to £500k and then 4% from £500k to £1m and then 5% for properties over £1m. But unlike income tax, which is “tiered” and different rates kick in at different levels, stamp duty is a “slab” tax where you pay the rate on the whole purchase price of the property. On shares, stamp duty is charged at a flat rate of 0.5% on all share purchases. Figures correct as of May 2011.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
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.
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.
Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.
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.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
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.
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).
Everything you own: all your assets (property, cars, investments, savings, insurance payouts, artwork, furniture etc) minus any liabilities (debts, current bills, payments still owed on assets like cars and houses, credit card balances and other outstanding loans). When you’re alive this is called your wealth; when you’re dead, it becomes your estate.
Annual management charge
If you put money in an investment or pension fund, you’ll not only pay a fee when you initially invest (see Allocation Rate) but also a fee every year based on a percentage of the money the fund manages on your behalf. Known as the AMC, the actual percentage varies according to the particular fund, but the industry average for active managed funds is 1.5%.