What is an ISA?
Individual savings accounts, or ISAs as they're more commonly known, are tax-efficient ways to save and invest your money. Introduced in 1999, they now hold more than £385 billion of the UK's savings and investments. So what makes them so popular with savers and investors alike?
Cash ISAs are a form of savings account offered by banks and building societies. Just like other accounts, any money you save into them earns interest but, unlike traditional savings accounts, this interest is paid tax-free.
Stocks and shares ISAs invest in the stockmarket through investments such as shares, government bonds (gilts), corporate bonds and collective investments such as investment trusts, unit trusts and open-ended investment companies (OEICs).
The latest kid on the ISA block is the junior ISA (JISA). These operate just like the adult version, but with a smaller £3,600 allowance that family and friends can use.
The key benefit of any ISA is its tax-efficiency, which can help your money to grow faster than if it was held in a comparable taxed product – this can make a significant difference to the amount you receive. Basic-rate taxpayers pay 20% tax on their interest, higher-rate taxpayers 40% and those paying tax at the additional rate pay 50%.
To illustrate, if you had £1,000 in an ISA paying 3% interest, this would earn you £30 over a year. If you were a basic-rate taxpayer, this would reduce to £24, with it falling to £18 or just £15 for higher-rate and additional-rate taxpayers respectively.
"Cash ISAs are a no-brainer for anyone with savings," says Sue Hannums, director of savingschampion.co.uk. "Even if you don't pay tax now, you might in the future so it's worth sheltering as much of your savings as you can."
For stocks and shares ISAs, the tax position depends on the type of investment you hold. If you're investing in stocks and shares that pay dividends, after the deduction of 10% tax at source, there's no further tax to pay. So for basic-rate taxpayers there's no difference, but higher and additional rate taxpayers do benefit though - saving a further 22.5% and 32.5% in tax respectively.
With fixed-interest investments such as gilts and corporate bonds, any income is classed as interest and treated in the same way as a cash ISA. This means all taxpayers are better off investing within the ISA tax wrapper.
You will also benefit from a capital gains tax (CGT) exemption by holding investments in a stocks and shares ISA. If you hold your investments outside of an ISA wrapper, you will be liable to CGT if you've made profits in excess of £10,600 when you sell them. You will be charged at a rate of 18% if you're a basic-rate taxpayer or 28% if you're a higher-rate taxpayer.
The annual limits
Whether you stand to save a little or a lot in tax, because of the relief ISAs offer there are limits on the amount you can put into an ISA each tax year.
For the 2011/12 tax year the maximum you can pay in is £10,680, of which up to half of this, £5,340, can be in put into a cash ISA. Your ISA allowance increases each tax year in line with inflation, with the rise based on the annual increase in the consumer prices index from the previous September.
The indexed allowance is then rounded to the nearest £120 to make it easy to make regular monthly payments. This means the annual allowance for the 2012/13 tax year will be £11,280, of which up to £5,640 can be saved into a cash ISA. This equates to a monthly contribution of £940, of which up to £470 can be paid into a cash ISA.
Although there are no charges on cash ISAs, there are some to look out for with stocks and shares ISAs. Many funds have an initial charge, which could be anything up to 5.5%, although you can get this reduced or waived altogether through a fund supermarket. Annual charges are also common, and can be up to 2%, but again these can be waived by the fund supermarkets.
You'll also face dealing charges if you want to buy and sell shares within a self-select ISA. These start from as little as £1.50, with many providers offering special deals for frequent traders.
Some self-select ISA providers will also charge an administration fee, so you'll need to weigh up these charges too. It makes sense to shop around for lower charges according to Jason Witcombe, director of Evolve Financial Planning.
"Investment returns are low at the moment, typically around 3.5 to 4% a year, and you don't want to see half of this swallowed up by an annual charge," he says.
Transfers and withdrawing money
Although ISAs are fairly straightforward, there are some catches to be aware of. First, think carefully if you want to withdraw any money. Even if you want to top up your ISA later, you cannot do so unless you have any unused allowance for that tax year. The withdrawn money is viewed as part of your used allowance.
If you want to transfer your ISA between providers be aware of the rules. As well as transferring between cash ISAs or stocks and shares ISAs, you can also transfer money from a cash ISA to a stocks and shares ISA, but not the other way around. If you do want to transfer, you can move all or part of previous tax years' ISAs but you have to transfer all of the current tax year's contributions at the same time.
Most importantly, if you're transferring, don't withdraw the money as it will lose its tax-efficient ISA status. Instead, complete a transfer form with your new ISA provider and it'll do all the legwork on your behalf.
Available from 1 November 2011, the Junior ISA will replace child trust funds (CFTs), which have been phased out. Junior ISAs will have a £3,000 limit and will be offered by high street banks, building societies and other providers that currently offer ISAs to adults. You can invest in either stocks and shares or cash. But, unlike CTFs, there will be no government contributions into each child’s savings pot. Money invested in Junior ISAs will be “locked in” until the child is 18, and the ISA will default to an adult one.
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.
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.
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 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.
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).
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.