Individual savings accounts, or ISAs, were introduced in 1999 to encourage saving and investment. While their tax breaks make them an attractive option, it's important to understand the rules to get the most out of them.This guide will give you the lowdown on everything from what an ISA is and the different types available to the tax breaks, investment strategies and how to transfer previous ISAs to a new one.
What is an ISA?
An ISA is a tax-efficient savings and investment vehicle. There are two main types - a cash ISA, which is like a savings account offered by banks and building societies and is available to open from age 16; and a stocks and shares ISA, which invests in the stockmarket, either directly into shares or through a collective investment such as a unit trust or investment trust. These are available to anyone over the age of 18.A self-select ISA is a form of stocks and shares ISA, where you can build your own portfolio from a wide range of investments including funds, shares, gilts (government bonds), bonds and exchange traded funds.The junior ISA is the new kid on the block. This was announced in October 2010 as a replacement for the child trust fund. Although the details are yet to be finalised, the Treasury announced that it will allow investments in cash and stocks and shares, with the child unable to touch the money until they reach 18.
What are the ISA allowance limits?
Each tax year, there's an ISA allowance you can use for your tax-efficient savings and investments. In the 2011/12 tax year, the allowance is £10,680.Of this, up to £5,340 can be paid into a cash ISA, with the balance going into a stocks and shares ISA. You can even put the lot into a stocks and shares ISA if you like.
Remember you can't open more than one cash ISA and one stocks and shares ISA each tax year.
What are the benefits?
Whatever type of ISA you plump for, there are a number of tax breaks that will boost your savings and investments.For cash ISAs, you receive any interest tax-free. With a stocks and shares ISA, you'll benefit from its capital gains tax-free status. Capital gains tax at 18%, or 28% for higher-rate taxpayers, is charged on any gains you make in excess of the annual allowance.
Understanding stocks and shares ISAsThe income tax benefits on a stocks and shares ISA depend on the type of investment you hold. If your money is held in shares that pay dividends, although you won't be able to claim back the 10% tax credit, there's no further tax to pay. While this doesn't benefit basic and non-taxpayers, it does save higher-rate taxpayers from paying a further 22.5% tax on their dividends.However, even if you're not a taxpayer, it's worth taking advantage of your ISA allowance. You may become a taxpayer in the future, at which point you'll be glad you sheltered your money in a tax-free environment.
4 How do I decide which type of ISA to go for?
Whether you go for a cash ISA, a stocks and shares ISA, or a combination of the two will depend on your financial objectives and attitude to risk.Unlike a cash ISA, the value of a stocks and shares ISA can go down as well as up. These can rise and fall in value but, over time, the reward for taking this additional risk could be a better return than if you'd put the money in a cash ISA.It's sensible to avoid a stocks and shares ISA if there's a possibility that you'll need the money in the short term. Ideally, to ensure you don't get caught out by a surprise stockmarket tumble, you need to be able to leave your money in a stocks and shares ISA for at least five years.
5 What does it cost to have an ISA?
This depends on the type of ISA you select. There's no charge on a cash ISA, but you'll pay an initial fee (around 5%) and an annual charge (around 1.5%) on a fund-based stocks and shares ISA, although sometimes the initial fee can be discounted.With a self-select ISA, you'll need to take into account the dealing costs if you buy shares (these vary from provider to provider, from 1% of the deal to approximately £15, or £7-£8 for frequent trades), plus there may also be an annual administration fee (again, this varies greatly with different providers).
6 How do I top up my ISA?Topping up an ISA is simple. Providing you haven't already paid in more than the annual allowance, and there aren't any rules to prevent it, you can make an additional payment whenever you like, as long as it's within that tax year - any money put in once the tax year ends will count as if you're opening a new account.One thing to bear in mind if you have a self-select ISA is the cost of topping up. If you're buying shares you'll be charged a dealing charge each time, so you may prefer to invest larger amounts less frequently rather than drip-feed your ISA.
7 What happens if I take money out of my ISA?Providing there are no terms and conditions to prevent you withdrawing money, which may be the case on a fixed-rate cash ISA, you can take money out of your ISA whenever you like. The catch, though, is that once you've taken it out, you can't then replace that part of your annual allowance.Taking money out of an ISA also means you will lose the tax breaks, unless you transfer to another ISA.
8 Can I transfer money from one ISA to another?If the interest rate or investment performance on your ISA is looking a bit shabby, it's easy to transfer to another provider. Rules are in place regarding how you do this. To keep your tax-free ISA status, never withdraw the money yourself. Contact the new provider and it will oversee the transfer process on your behalf.While you can transfer part of a previous tax year's ISA, you have to transfer this year's ISA in its entirety. You can also transfer money you've saved in cash ISAs into stocks and shares ISAs. However, it doesn't work the other way around.
9 Should I save regularly or pay in a lump sum?The answer to this depends on your circumstances. Sticking a lump sum in at the beginning of the tax year will ensure you get the maximum benefit from your allowance. However, many people don't have the readies and prefer to plump for a monthly payment into their ISA.The good news if you're investing in a stocks and shares ISA on a regular basis is you get to take advantage of 'pound cost averaging'. This means that because your monthly payment will buy different numbers of units each month, depending on their price, when prices are low you'll be able to buy more units.As an example, say you pay £200 a month into a stocks and shares ISA. In the first month, the price of units is £10, so you buy 20 units. The following month the price has fallen to £8, so you buy 25 units, and in the third month they're back up to £10, so you have another 20.This would give you 65 units, which at £10 a unit would be worth £650. In comparison, if you'd invested £600 at the beginning, you'd have 60 units, worth £600.Remember, though, it doesn't always work in your favour. If prices rise steadily you'll end up with fewer units than a lump-sum investor.
10 Is my money protected?Yes, you're protected under the Financial Services Compensation Scheme (FSCS). If you have a cash ISA with a provider that becomes insolvent, you will be able to claim compensation for the first £85,000. For investments, the limit is slightly lower at £50,000.Although it's unusual for an ISA provider to go bust, it's sensible to keep your savings and investments with any one firm below the compensation limits.In addition, the FSCS protection limit is per authorised institution and not per bank; many banks come under the same umbrella, so you should spread your assets.An example of this is Halifax: if you also hold deposits with Bank of Scotland, Birmingham Midshires, Intelligence Finance, The AA or Saga you will only be covered up to the value of the £85,000 limit, as these are all authorised under the HBOS brand rather than each account being protected for this amount individually.
This article was originally published in our sister magazine Moneywise, which ceased publication in August 2020.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
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