What is an ISA?

What are ISAs and why is it a good idea to take one out?

To deal with the basics first, ISAs are Individual Savings Accounts, introduced by Chancellor Gordon Brown in 1997 as a replacement for PEPs and TESSAs. As the name suggests they are designed for use by private individuals. To qualify to take out an ISA, you have to be UK-resident and over the age of 18, although it is possible to take out a cash mini-ISA if you are over the age of 16.

These days, ISAs comprise two elements: cash, and stocks and shares. The cash element is just what it says it is, usually linked to some form of deposit account, whilst the stocks and shares element actually covers a wide range of investments, including investment funds and fixed-interest securities, such as UK government gilts and corporate bonds. The investment funds included in this part of an ISA don’t necessarily have to be invested in shares either.

The key point to understand is that an ISA is not an investment. It is wrapper into which investments can be put and the scope of these potential investments is extremely wide. For example, investments that qualify for inclusion under the ‘stocks and shares’ description comprise direct shareholdings, gilts, bonds, some life assurance products and pretty much the full range of collective investment schemes, including unit trusts, open-ended investment companies (OEICs), investment trusts and new types of funds available under European UCITS legislation.

There are, of course, limits on how much you can put into an ISA in any one tax year, and the amounts you can invest will depend upon the type of ISA you are taking out. For there are two different types of ISA, mini-ISAs and maxi-ISAs. You can invest in one maxi or one or two different mini-ISAs in a tax year, but you can’t invest in both types in the same year.

A mini-ISA separates out the two elements, so that you take out either a cash mini-ISA or a stocks and shares mini-ISA. You can invest in both types in the same tax year, but you can’t choose two cash mini-ISAs or two stocks and shares mini-ISAs. The annual maximum investment limits for mini-ISAs are £3,000 for the cash version and £4,000 in a stocks and shares type.

Maxi-ISAs are more straightforward. You can only invest in one each tax year, but can invest up to £7,000. A Maxi ISA must have some investments in what are regarded as ‘stocks and shares’ by the ISA rules, but can also include a cash element as well. The maximum amount that can be put into cash within a maxi-ISA is £3,000, which case the maximum left for stocks & shares is £4,000. But the whole £7,000, or indeed any amount up to that figure, can alternatively be put into investments qualifying for the stocks & shares element.

And why should you want to take advantage of these sometimes complicated rules? The answer is tax-efficiency. The attraction of taking out an ISA is that, in terms of personal liabilities, the proceeds are tax-free.

Investments held within an ISA are not liable for capital gains tax, nor do any dividends you receive from them have to appear on your income tax form. However, the income element is not as attractive as it used to be. Until April 2004, all the income generated within an ISA was tax-free too, but now only fixed interest (i.e. bond) and cash investments remain entirely free of tax. Basic-rate taxpayers have to pay 10 per cent tax on equity income regardless of whether this is held inside or outside an ISA, although you will not notice this happening as the deduction is made within the fund or direct from the share dividend.

This change has had the effect of dampening down the enthusiasm for ISAs amongst some investors. And there is a further argument that, given the amounts involved, the CGT exemption is not as attractive as it might seem. Paul Ilott, senior investment adviser at financial advisers Bates Investment Services, observes: “We have looked at the income tax angle, as you might have guessed, but also the capital gains tax angle and how beneficial that actually is to a small investor. I would suggest that over a ten-year timeframe, unless you were investing in a highly speculative fund that could do extremely well, capital gains tax savings for a very small investor are more questionable.”

However, he adds: “We know what the current tax regime is, in terms of higher-rate and basic-rate tax liabilities, but of course, many savers are saving over the very long term, at the end of which tax liabilities, outside of PEP and ISA wrappers will then be unknown. So, by building up a tax-efficient pool of money, at least you are protecting yourself from any future rises in general tax rates that might apply to other forms of savings.”

Anna Bowes, savings and investments manager at Chase de Vere Investments, points out: “Most investors start by building up their portfolios. For a lot of people, they are not going to be in the fantastic position of having a large lump sum to able to choose all the funds they want immediately. If you were in that situation, that is what you would do and then you would put a tax wrapper around those investments if you can, a pension, for example, and then use up your ISA allowance, because ultimately, it is no more expensive to have your money in an ISA and it may be that it is more tax-efficient.”

She adds: “This is on two counts. There is no extra personal tax, so if there is dividend income and you are a higher-rate taxpayer, you do not have to pay the extra tax. Also you don’t have to worry about encashment in the future; it doesn’t have to go on your tax return, and because it is an ISA, it is not going to generate any capital gains tax.”

And Paul Ilott focuses particularly on the usefulness of ISAs for retired investors looking to protect their level of income, as an example of how effective the tax breaks can be. “You also the ability to get out of the age-related allowance trap. This is where you are an investor over the age of 65, you may be in receipt of an age-related personal allowance, which allows you to earn a little bit more before tax starts to bite. But as soon as your income goes over £19,600 in the current tax year, for every £2 over that threshold, your allowance is reduced by £1. This effectively means that if you have savings income, say from a bank or a building society, where the int-erest payable takes you over that threshold, the effect is equivalent to a 30 per cent tax-take.

But if you are willing to move some of that deposit money out of a taxable environment and into an ISA wrapper, with a fixed interest fund or a cash ISA or even an equity fund, if you prefer to take that risk, this removes the money from that tax trap and actually saves tax at the equivalent of 30 per cent.”

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All you need to know about investing in ISAs