All you need to know about investing in ISAs:

The straight facts on everything from investment limits and investment choices to costs and getting advice

Individual savings accounts (ISAs) were introduced in 1997 in a bid to encourage more of us to save and invest. An ISA is not an investment itself, but a wrapper in which other investments can be held tax-free.

Investments held within an ISA are exempt from capital gains tax. And until April 2004 all income generated within an ISA was tax-free too, but now only bonds and cash ISAs remain 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. So unless there is capital growth from an investment there is little incentive for basic-rate taxpayers to gather their equities under the ISA umbrella.

However, higher-rate taxpayers still have a huge tax advantage. Outside an ISA, higher-rate taxpayers have to pay the full 32.5 per cent tax on dividend income. Within an ISA, they will only be taxed at a rate of 10 per cent on all dividends.

What is the annual ISA allowance?

Changes to the ISA rules were introduced in 2008 to both simplify their structure and encourage more people to take up their allowance.

The allowance has risen from £7,000 to £7,200 and the maxi- and mini-ISA distinction has been scrapped. Under the new rules it is possible to invest up to £7,200 in a stocks and shares ISA, or up to £3,600 in a cash ISA and the balance, up to £3,600, in a stocks and shares ISA.

Personal Equity Plans (PEPs), one of the forerunners of ISAs as tax-efficient savings vehicles are now known as stocks and shares ISAs. Existing maxi and mini-ISAs stocks and shares ISAs are now simply referred to as stocks and shares ISAs, while mini-cash ISAs and TESSA Only ISAs (TOISAs) have become just plain cash ISAs.
 
What can I put in my ISA?

There are now just two components to ISAs: cash and stocks and shares.
The Cash element can be either a deposit, like a normal savings account provided by a bank, or a money market fund. Money market funds pool investors’ cash and spread it across a range of deposits on the wholesale money markets.

It is important to shop around for the best cash ISA rate. A little research online can prove very rewarding because sometimes the best rates can be paid by the smaller building societies rather than the major high street banks.

The main attraction of cash ISAs is that you will not lose your capital and all interest is tax-free. However, as the lowest risk investment, cash tends to pay the lowest returns. For savers with a longer-term investment horizon that want to achieve higher returns, stocks and shares ISAs are normally the preferred option.

Stocks and shares ISAs can invest in a much wider range of assets, which may often be more volatile but can provide much higher rates of capital growth or income.

You can choose to invest in unit trusts or Open Ended Investment Companies, which are generally considered the best option for novices.

Investors’ money is pooled together and a specialist fund manager will buy and sell shares for you. One of the advantages is that they enable you to access a diversified portfolio of stocks or bonds, which is far less risky than holding individual shares.

There are a huge number to choose from, ranging from passive funds that just simply track an index to very aggressive funds where a specialist manager takes a high-conviction approach and only holds a small number of stocks. Other funds will invest in corporate or government bonds, property, gold and a whole host of other asset classes.

Funds are categorised depending on what they invest in and what their objectives are, such as UK Equity Income, Global Growth and Far East Specialist. Index trackers following the UK market are found in the UK All Companies sector.

An increasingly popular choice among investors are multimanager funds. These are basically funds that invest in perhaps 15-30 other funds and so, in theory, are able to pick the best specialist managers in each asset class or region.

Another type of collective fund investing in a broad range of holdings are investment trusts. These are companies that make their profits by buying and selling shares in other companies.

Because of their company structure, they have more freedom than unit trusts and OEICs, and can be more aggressive in their investment style. They have more freedom to borrow money to invest, in order to enhance investor returns (called gearing or leverage) and so might suit more aggressive investors or those with a long timescale.

One downside is that, like all companies, they issue shares that are traded on the Stock Exchange. So, whereas the price of units in a unit trust is directly linked to the value of its investments, the price of shares in an investment trust depends on how much investors are willing to pay for them. If demand is low and investors are selling, the share price can fall well below the value of the trust’s investments (the trust’s net asset value), in which case it is said to be trading at a discount.

Bonds are another popular home for investors’ money, particularly in light of their positive tax treatment within ISAs. You can hold UK government bonds, or gilts, and corporate bonds directly, but most investors prefer to buy bond funds. These again provide the comfort of spreading your money across a diversified portfolio of holdings and package the different income payments into a single regular payment.

More experienced investors, or those that have considerable existing shareholdings, can shelter these within an ISA. This includes ordinary shares, preference shares and convertibles and you can invest in any recognised stock exchange in the world.

Many stockbrokers offer self-select ISAs that enable investors to select any of the above investments.

The right investment to put into an ISA depends on your individual circumstances. The factors you should consider include what other investments you hold, your appetite for risk, your investment time horizon, your investment experience, and whether you are looking to invest for capital growth, income, or a mixture of the two. If you are in doubt about where to invest your money, seek advice. See Getting Advice, below.

How much will an ISA cost?

The cost of an ISA can be broken down into different charges with the cost of the ISA wrapper itself and the underlying investment the main expenses. If you switch investments within the wrapper or are dealing shares, further transaction costs can be racked up.

Cash ISAs build their costs into the product and this is reflected in the rate they pay.

Many fund managers make no additional charge for the ISA wrapper and only levy an initial charge and annual management fee for the underlying funds.
More and more ISAs are now being bought through fund supermarkets. These are provided by most of the largest brokers, such as Hargeaves Lansdown, Chelsea Financial Services, Bates and Bestinvest. FundsNetwork is another popular choice.

Fund supermarkets offer distinct advantages over going direct to fund managers.

They provide access to literally thousands of funds and accounts can easily be opened and managed online.

Most do not charge an ongoing or set up fee and offer heavily discounted initial charges on funds, saving you up to 5.25 per cent per fund.

The main cost will then be the annual management charge on the fund, which can range from 0.3 per cent to 1.75 per cent.

The most likely type of ISA to levy additional charges is a self-select plan, particularly if advice is being given on which stocks and shares to buy.

There is typically a flat set-up fee to establish the ISA and an annual charge, often levied as a percentage of the portfolio value.

Check very carefully if your chosen company does make an additional charge for the ISA wrapper. If it does, see how this weighs against the potential tax benefits or whether it is worth paying because the ISA provider is supplying you with useful services such as portfolio valuations, market commentary or online dealing services.

Cost for the underlying investments, such as trading in shares and corporate bonds or gilts directly will incur dealing commission. Some will charge a percentage, such as 0.5 per cent per deal, but most now charge a flat fee, typically of around £10 per trade.

Purchases of shares also incur stamp duty of 0.5 per cent.
Investment trusts tend to have no initial charge and simply levy an annual management charge, often less than 1 per cent. As they are listed companies, you will incur stockbroking costs as with any other share. Many investment trusts run their own savings schemes.

Getting advice

There is a wealth of information about ISAs in the press and on the internet.
The fund supermarkets also provide a wealth of data on funds’ performance along with news and views on the economic outlook and which fund managers they back.

Organisations such as the Investment Management Association (IMA) and the Association of Investment Companies (AIC) also provide generic information about funds.

Interest rates for cash ISAs should be checked regularly in newspaper best-buy tables, which can be found in their personal finance sections on Wednesday and Saturday and on websites, such as moneysupermarket.com.

If you don’t feel confident about choosing an ISA yourself, an independent financial adviser (IFA) can help. There are various organisations that can send you details of IFAs in your area, such as www.unbiased.co.uk.

Bear in mind that advisers from banks, building societies and life insurance companies may not be independent and only allowed to recommend the products of the company they work for.

It is worth visiting a number of IFAs to see which you feel most comfortable with. On your first visit, the IFA must undertake a fact-find and ask you about your financial circumstances to ensure an ISA is suitable. He or she will then draw up a list of recommended ISA funds that you can discuss.

To cover the cost of his or her services, the IFA will either take commission from fund provider. The standard rate is 3 per cent of the initial investment and 0.5 per cent per year thereafter. Discount brokers, such as the fund supermarket providers detailed above will reimburse you with the initial charge and just take the annual payment, which is funded by the fund manager. Other advisers will charge you a time-based fee, much like an accountant or solicitor.

A lot of IFAs are only able to recommend unit trusts or OEICs. If you have your heart set on investment trusts, you might be better off consulting a stockbroker.

A stockbroker should be your first port of call if you want to invest directly in equities, gilts or corporate bonds. Most stockbrokers offer three types of service: execution-only, where they carry out your instructions to buy and sell securities, advisory, where they advise on suitable holdings, and discretionary, where they buy and sell on your behalf. The cost for these services tends to increase the more input they have.
 
Monthly Saving Schemes

If you don’t have much money to invest now, it is a good idea to set up a monthly savings scheme, which will deduct your ISA contribution straight from your bank account and invest it straight into your ISA.

This means that you do not have to shell out thousands of pounds in one go but you ensure you use your annual allowance.

The majority of fund managers offer monthly investment facilities into their unit trusts, investment trusts and OEICs, and you can add to these now and again with ad hoc lump sums. Some investment trust savings schemes accept as little as £20, although the minimum for a unit trust-based scheme is likely to be closer to £50.

Monthly saving is useful if you are investing from your regular salary, but it can also help to combat the ups and downs of share prices. By investing every month, you will benefit from the effects of what is called pound-cost averaging. By investing the same amount each month, you will buy more shares or units in a fund when prices are low, and less when prices are high. In this way, the average price you pay for your shares or units will be less than their average price over that period.

TRANSFERRING YOUR PEP OR ISA

Even though you can no longer invest in a PEP you can transfer your existing investment to an ISA provider if it no longer meets your needs or you better returns can be achieved elsewhere. You can also transfer an ISA to another ISA provider if you want to.

There are several reasons to consider a transfer:

The process for transferring a PEP or an ISA is the same. You need to obtain a form from the new plan manager who will then organise the transfer for you. Transferring your investments may involve charges.

There can be an administration fee of between £25 and £50 and investors with share PEPs may find that their stockbroker adds dealing charges to the transfer bill or a fee to cover the cost of re-registering the shares in the new plan manager’s name.

One way to cut down on transfer costs might be to consider switching to another ISA offered by the same management group, as they will usually offer a discount. However, there will not always be a suitable ‘in-house’ alternative.

You can also transfer a cash ISA to another provider, but the ISA provider has to arrange the transfer for you. The ISA rules allow mini-cash ISA providers up to 30 days to complete the transfer, during which time you may lose out on interest and may not actually have access to your money.

There may be a penalty to pay if you do decide to switch and some providers will not allow transfers into their leading rate products as they do not want to pay out the more attractive rates on larger funds.