A basic guide to ISAs
Whether you're saving for something specific like a wedding or house, want to generate a regular income from bonds and fixed-interest products, or are seeking to profit from some of the world's more exotic stockmarkets, then an ISA should be your first choice when looking for an investment or savings vehicle.
ISAs were introduced in April 1999 as the Labour Government's successor to personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs). Not investments in their own right, ISAs are wrappers that can be placed around a diverse range of investments including savings accounts and stocks and shares.
In spite of the new name and several rule changes, the fundamental benefit of this investment vehicle has remained the same - tax-efficiency. Anything you place inside an ISA wrapper is exempt from income and capital gains tax. Growth of investments inside an ISA is also tax-free, although the changes to taxation of company earnings in 2004 slightly diminished this benefit for ISAs investing in stocks and shares.
From April 2004, fund managers were unable to reclaim the 10% tax credit on dividends. For higher-rate taxpayers there is still a tax saving but, with the loss of the tax credit, basic rate taxpayers pay exactly the same tax on dividends as they would have if they'd held the investment outside the ISA wrapper.
Although this has taken some of the shine off ISAs, they still offer significant tax advantages. In particular, interest on cash is received gross and any investments are exempt from capital gains tax. Even if you're not a taxpayer or are worried about capital gains tax, you should consider an ISA. Your circumstances may change, making previous years' ISAs an invaluable tax shelter for your money.
The different types
There are two types of ISA - the cash ISA, and the stocks and shares ISA. The most popular option, cash ISAs are offered by banks and building societies and are essentially tax-free savings accounts. Interest is paid regularly, so your money is guaranteed not to reduce in value. As with ordinary savings accounts, rates vary substantially.
While there are plenty of great deals available, there are also lots paying dismal rates of interest. The accounts also share many of the features of standard savings accounts, including bonuses, fixed rates, notice periods and penalties. As a result, you need to think about how much access you'll need to your money, before making your choice.
The other type of ISA is the stocks and shares ISA. These can invest in a wide range of assets, including authorised unit trusts and open-ended investment companies (OEICs), investment trusts, gilts (providing they have a term of at least five years remaining) and shares. Unlike their predecessors, PEPs, there are no geographical restrictions on where you can invest.
The most common form of stocks and shares ISA is one that invests in a collective investment such as a unit trust or investment trust. With these you benefit from diversification, as well as the expertise of a fund manager, who will make investment decisions on your behalf.
Alternatively, if you prefer more control over your investments, you could choose a self-select stocks and shares ISA. These allow you to pick the shares you want to invest in and when you want to invest in them, making them ideal for those buying shares on a regular basis.
You should also be aware of stakeholder ISAs. An ISA gains the stakeholder product label if it meets certain conditions set by the Government.
For cash ISAs, there must be no charges, the minimum deposit must be £10 or lower, and you should be able to pay into your account by cash, cheque, direct debit, standing order or BACS. Also, the interest rate must never be more than 1% below the base rate and you must be able to make unlimited withdrawals, with the money available within seven days.
For stocks and shares ISAs, two stakeholder products apply - the medium-term investment product and the smoothed medium-term investment product (which works in a similar way to with-profits to smooth out returns). These products also need to meet certain criteria, including a minimum investment of £20 or less, an annual charge of 1.5% or less for the first 10 years, with a charge of 1% thereafter. Most importantly for cautious investors, no more than 60% of the fund can be invested in shares.
How much you can invest
You can invest up to £7,200 into ISAs every tax year. Withdrawals are permitted, but once you've taken the money out of your ISA you cannot replace it unless you still have some allowance remaining. However, exactly how you invest this money is being simplified. New rules announced in the 2007 budget by Gordon Brown came into effect in April 2008 and aimed to remove some of the confusion surrounding ISAs.
Previously there were mini ISAs and maxi ISAs. Mini ISAs were either cash or equity while a maxi ISA combined the two. However the set-up was considered confusing so mini and maxi ISAs were scrapped in April 2008 and replaced by cash ISAs and stocks and shares (or equity) ISAs.
At the same time the tax free allowance for every UK adult was raised from £7,000 to £7,200 although a maximum of £3,600 can be saved in a cash ISA.
Other changes include the scrapping of Personal Equity Plans or PEPS which were the forerunners of ISAs. Existing PEPs became stocks and shares ISAs and subject to exactly the same rules and tax breaks.
The other important change was the ability to transfer money held in cash ISAs into stocks and shares ISAs. This will allow you to start your savings in a cash ISA, if you don't want to risk them on the stockmarket, and then roll them over into stocks and shares ISAs when you've built up a larger fund and are happy to take the risk.
Unfortunately, however, this won't work the other way round, although the ability to switch out of equities and into cash would be useful for older investors looking to reduce the risk of their portfolio in retirement.
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.
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).
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.
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.
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.
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).
Created in 1968, BACS is a not-for-profit industry body, owned by 16 of the leading banks and building societies in the UK and Europe. All direct debits, standing orders, credit card payments, personal loans and the vast majority of salary cheques are processed through BACS. In 2010, 5.7 billion UK payments with a total value of £4.06 trillion were processed through the system.
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.