Boost your ISA income with stocks and shares
It is surprising how many people are still missing out on the wonders of ISAs. Four out of 10 people are not using their annual ISA allowance at all and only one in 10 chooses to maximise their savings in a stocks and shares ISA, according to recent research by Fidelity.
To a certain extent, the lack of take-up is due to affordability - not everyone has sufficient spare cash to invest the maximum every year. But there appears to be a lack of recognition among some savers of how valuable the tax breaks on ISAs can be, especially when it comes to income.
The difference in returns earned by investing inside, rather than outside, an ISA can be significant. A 50-year-old basic-rate taxpayer who placed £10,200, the current annual ISA allowance, into a UK equity fund each tax year, assuming an annual total return of 6.5% per year, before charges, would have amassed £312,447 by age 65.
Read our round-up of the best cash ISA rates
The same investment outside an ISA, after suffering tax deductions, would have grown to £290,499, or 16% less. Higher-rate taxpayers at 40% would see an even greater difference between the two, with the ISA returning 28% more.
The ISA allowance wasn't always as high as it is now. Nevertheless, those who had invested the maximum amount in equity ISAs from their inception in 1999 up to 31 December 2010, totalling £87,600, could have accumulated £125,791, based on an investment in the FTSE all-share index.
For more on equity ISAs read: Equity ISAs trounce cash in 2010
Besides being a good way of accumulating capital, ISAs are ideal for income seekers, especially at retirement, because the income they generate is not taxable. In the case of bond funds held within ISAs, managers can reclaim the 20% tax deducted from interest payments, so the income is paid tax-free. The 10% tax credit on dividends cannot be reclaimed.
Avoid the 'age allowance trap'
However, there is still a major advantage because ISA income will not count against the age allowance, helping to protect investors against falling into the 'age allowance trap'.
The flexibility of ISAs in allowing penalty-free capital withdrawals means they also compare favourably with pensions. Until now, those who opted to take an income direct from their pension fund rather than buying an annuity could take out up to 20% more than an annuity would have provided.
However, from 6 April, the amount of drawdown pension that can be taken will be reduced to the same level as the annuity (as defined by the government actuary's department).
As with any investment strategy, ISA investors who need income should ensure that they have a balanced portfolio with their investments spread across different asset classes, including cash, bonds and equities.
Cash is not normally a problem, as most people have erred towards putting the maximum in cash ISAs, but they have consequently suffered from low interest rates over the past few years. After a buoyant period since early 2009, corpporate bond yields are also coming down.
Equities by contrast have started looking increasingly attractive.
Individual shares are not only offering some attractive yields but also the prospect of strong growth. The dividend yield on FTSE 100 stocks, currently just shy of 3%, is forecast to increase by 16% in 2011, according to Barclays Wealth.
Bank of England base rate, on the other hand, is only expected to rise by 0.25 percentage points at most.
Companies have suffered during the financial crisis and some, notably the banks, stopped paying dividends altogether. But businesses generally have worked hard to cut their costs and get their finances into shape, which is resulting in improved profitability and scope for future dividend increases.
They are also in a better position to cope in inflationary environments. Darius McDermott, managing director of intermediaries at Chelsea Financial Services, points out: "Shares tend to do well in inflationary periods because companies can put their prices up, which also enables them to maintain their dividends."
Other ISA options
There are various ways in which ISA investors can tap into equity income. Existing holders of cash ISAs can also switch their savings into equities, although there are no guarantees with shares and cash savers should consider the risks carefully.
Stockmarket investments should always be bought with a five to 10-year time horizon. The most obvious option is to buy high-yielding shares direct but the lower-risk approach is to invest through pooled funds, via unit trusts, OEICs (open ended investment companies) or investment trusts.
We asked a number of experts for their favoured choices in each category - any of which can be placed under the ISA tax umbrella.
This article was originally published in Money Observer - Moneywise's sister publication - in February 2011
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.
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).
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
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.
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
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.
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).
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.