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


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