Your top 15 ISA questions
While the government wants us to spend to kick-start the economy, having enough money stashed away is vital if you want to make sure you get through the current economic crisis in the best possible shape. If you’re searching for a savings vehicle to make the most of your money during the downturn, then an ISA is a good starting point.
However, before taking the plunge you need to understand the basics to pick the best account for your needs.
Here we answer your top 15 ISA questions.
1. What is an ISA?
ISA stands for individual savings account; the term was introduced by the government in 1999 to encourage people to save more by offering tax incentives. The ISA replaced personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) – two other tax-free savings vehicles.
An ISA is not an investment in its own right, rather, it is a tax-efficient ‘wrapper’ that can be placed around a variety of investments, such as cash, or stocks and shares. This wrapper protects your investment from capital gains and income tax, meaning you don’t have to pay any tax on your interest or investment return.
2. What types of ISA are available?
There are two distinct types of ISA to choose from: cash, and stocks and shares.
A cash ISA is basically a bank or building society account, and so is inherently low risk and ideally suited to short-term or ‘emergency’ savings. It is a savings account that enables you to earn interest tax-free; you’ll get back the sum you initially invested, plus any interest earned.
The interest rate is also typically higher than that of an ordinary savings account. Like standard savings accounts, cash ISAs offer a choice of easy access options, or others that tie up your money for a specified period in return for a higher rate of interest.
And just as with other deposit accounts, up to £50,000 held in a cash ISA would be protected by the Financial Services Compensation Scheme should your bank collapse.
The second type of ISA is a stocks and shares ISA, also known as an equity ISA. It can be invested in a variety of investment funds, or individual stocks and shares, as well as fixed-interest investments such as corporate bonds. This type of ISA carries more risk because your return is not guaranteed and you may even lose money.
Yet the upside is that you may get higher returns over time by taking greater risk with your money and also benefit from the expertise of a fund manager who will make investment decisions on your behalf.
3. Why should I invest in an ISA?
ISAs remain one of the most beneficial savings plans because they are so tax-efficient. Basic-rate taxpayers who are usually taxed at 20% on interest earned on savings accounts do not pay any tax on interest earned on a cash ISA. If you’re a higher-rate taxpayer, you’ll make heftier savings, as you would otherwise face a 40% bill.
The tax benefits on stocks and shares ISAs are not as good as when they were launched. Since April 2004, basic-rate taxpayers pay the same tax on dividends as they would if they held the investment outside the ISA wrapper.
“However, higher-rate taxpayers still make some savings, as they avoid the extra 22.5% payable on dividend income,” says Tim Cockerill from independent financial adviser Rowan.
Importantly, investments are exempt from capital gains tax, so any growth is yours to keep.
4. What are the yearly limits?
Given the tax breaks, it isn’t surprising that the government has limited the sum you can invest in an ISA each tax year. Currently, you can put up to £7,200 a year in an ISA, dividing this sum depending on the kind of assets and risk level you want. For example, you can put the full allowance in the stockmarket, or you may want to hold some of the allowance in cash. However, the maximum sum you can save in a cash ISA is £3,600 a year.
5. Weren’t there some changes to the ISA rules last year?
There were important changes made in April last year, which simplified the ISA investment process. There used to be mini ISAs and maxi ISAs. Mini ISAs were either cash or stocks and shares, while a maxi ISA combined the two. However, this distinction was scrapped and replaced by the two basic forms; cash and stocks and shares ISAs.
Now, you can take a cash ISA from one provider, with the remainder of your overall allowance in a stocks and shares ISA from another provider, or hold it all with the same company.
6. Are there other rules I should know about?
Once you’ve invested your annual limit, you cannot pay more in, even if you have made a withdrawal.
For example, if you pay in the full allowance £7,200 but take out £1,000 the next month, you can’t put that £1,000 back in your ISA in the same tax year because, although your ISA holding might be below the limit, you’ve already used your annual allowance.
7. How can I pick the best ISA and where do I get hold of one?
There is a plethora of products on offer so picking the right one can seem daunting, particularly if you’re taking out an ISA for the first time.
Before you decide whether you should opt for a cash or a stocks and shares ISA, you need to consider your investment attitude and goals. For example, if you’re saving for a rainy day, you should opt for a cash ISA as the money you’ve saved won’t be at the mercy of the ups and downs of the stockmarket.
If, on the other hand, you are saving for your newborn child’s university fees, a stock and shares ISA is likely to give you a better return as long as you’re happy to take the investment risk.
Stocks and shares ISAs can be bought from independent financial advisers, fund supermarkets, brokers and high-street banks. Cash ISAs are offered by almost every bank and building society.
8. Ok, they sound great, but what is the cost?
You won’t pay a penny to save through a cash ISA. The only considerations are finding one to suit you with a competitive rate, and deciding how much you want to invest. The minimum deposit is often just £1.
However, for a stocks and shares ISA you generally have to pay a one-off set-up fee, which is between 4% and 5%, and there will be an annual charge, of between 1% and 1.5%.
Some companies reduce their charges during the ISA season, which runs for a few months before the end of the tax year. Also, many ISA funds are available at a lower cost through fund supermarkets or discount brokers, so shop around before you decide.
9. So should I start paying into one now?
If you want to make the most of this year’s ISA allowance, you will have to invest your allowance before the end of the 2008/2009 tax year, which is 5 April.
For anyone with money languishing in a savings account paying a paltry rate of interest, a cash ISA may offer a better deal. Even if the current environment means rates are relatively low, you’ll still benefit from tax-free interest.
When it comes to stocks and shares ISAs, it really depends on how much money you have free to invest and how much risk you want to take with it. If you have a fair amount and you don’t need instant access for the next five years or so, you could consider this route.
10. I want a better return on my ISA. What should I do?
Historically, equities have produced better returns than cash. “With this comes greater volatility and a long-term timeframe,” says Jason Witcombe from IFA Evolve Financial Planning. “But if you’re willing to go down this route and take a 10-year view, you could tilt towards riskier investments such as technology funds.”
For a steady, decent return on cash, find an ISA account with a long-term guarantee, such as one paying more than the base rate. “Returns are unlikely to be stellar, but at least you get the tax breaks,” says Witcombe.
But with the base rate reduced to 1% in February 2009 and further cuts expected, these accounts might not offer great returns. As an alternative, it’s worth looking for a high-interest, fixed-term regular-saver ISA account.
These accounts offer a fixed rate but you can’t withdraw the money for a certain period and you have to make regular monthly payments. On the upside, rates tend to be better and it will also encourage you to make monthly savings.
11. Can I transfer my money into an ISA?
Any money you have in an ordinary savings account or stockmarket investment outside an ISA can be transferred to one of these tax-efficient accounts, provided you stick to the annual allowance limit.
12. Can I transfer from one cash ISA to another?
You can transfer cash ISAs from a previous tax year from one provider to another without having an effect on the current year’s allowance – and you can also transfer the current year’s ISA to another provider.
Not all of the best-buy cash ISAs accept transfers so, if you are shopping around for a new home for last year’s cash ISA, you need to make sure you read the small print before comparing rates.
13. Can I move money between equity and cash ISAs?
After a rule change last April, you can transfer money from a cash ISA into a stocks and shares ISA. This will allow you to start saving in a cash ISA if you don’t want to risk your money on the stockmarket, and then roll some money into stocks and shares when you’ve built up a larger fund and are happy to take the risk.
However, it doesn’t work in reverse and you can’t move your money from a stocks and shares ISA back into a cash ISA.
If you want to transfer your cash ISA into a stocks and shares one, then the good news is the process is relatively simple. Contact the provider which you want to manage your investment and ask for an application form or, if you already have an ISA with them, a transfer form.
Then simply tick the right box, fill in the details of your cash ISA account, and it is done. How quickly the money is moved depends on the efficiency of the provider, but it shouldn’t take more than a few weeks.
14. What happens to my ISA when the new tax year starts?
If you don’t do anything, your ISA will remain in place and it will continue to earn interest or move in line with the market.
When a new tax year approaches, it is worth considering whether you want to add to your existing ISA or to start a new account with a different provider.
However, remember that any payment that goes into your current ISA after 5 April will count towards
your 2009/10 allowance – at which point it will be too late to open a new account.
If you want to shop around with a view to setting up a new ISA, you will need to cancel your automatic payments before the start of the new tax year.
15. Do low interest rates mean I should opt for an equity ISA?
Unfortunately, with interest rates at a low, there will be few appealing cash ISA options on the market this year.
“But you still get the uplift of the tax saving, and choosing an investment ISA is always a riskier choice,” says Cockerill. “On the other hand, while you always need some capital in cash, long-term gains are typically achieved through dipping a toe in the market.”
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.
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.
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.
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).
This is a mutual organisation owned by its members and not by shareholders. These societies offer a range of financial services but have historically concentrated on taking deposits from savers and lending the money to borrowers as mortgages, hence the name. In the mid-1990s many societies “demutualised” and became banks. One academic study (Heffernan, 2003) found demutualised societies’ pricing on deposits and mortgages was more favourable to shareholders than to customers, with the remaining mutual building societies offering consistently better rates. In 1900, there were 2,286 building societies in the UK; in 2011, there are just 51.
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.
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.
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.