What is an ISA?

All you need to know about investing in ISAs –from investment limits and investment choices to costs and getting advice

Investments held within an ISA are not liable for 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 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 are the limits for mini- and maxi-ISAs?

You can invest up to £7,000 in an ISA; you can either invest the whole lot in a maxi-ISA with a single provider or split your investment between mini-ISAs, using a different provider for each one if you want to.

If you open a maxi-ISA you can hold all of your money in a stocks and shares ISA, or divide the money; £3,000 in stocks and shares, £3,000 in cash and £1,000 in insurance.

Not all providers who offer maxi-ISAs offer the insurance or cash options, and if they do they may not be competitive. Mini-ISAs allow you to invest with the most competitive providers for each component. This does mean that you are limited to putting £3,000 in your stocks and shares mini-ISA. These limits cannot be exceeded even if you choose not to use one component at all.

When the insurance ISA is scrapped in April you will be able to hold up to £4,000 in the stocks and shares element of an ISA.

Money invested in previous tax years does not count towards these limits. These are the amounts you can
pay into your wrapper each year.

CAT-standard ISAs

From 6 April CAT-standard ISA products will be discontinued. CAT stands for ‘cost, access and terms’. These limit the level of charges and the minimum investment you are allowed to make and stipulate how quickly you can get at your money in the case of cash ISAs. CAT standards were voluntary and did not apply to all products. If you already have a CAT-standard ISA it will remain on the same terms and conditions.

CAT-standard products will be replaced by stakeholder products. The stakeholder cash deposit account will have to offer a interest rate no less than the Bank of England base rate minus 1 per cent and the stakeholder medium-term investment product will have the annual management charges capped at 1.5 per cent AMC for 10 years followed by 1 per cent thereafter.

What should I put in my ISA?

There are three components: cash, stocks and shares, and insurance.
Cash can be either a deposit, like a normal savings account, or a money market unit trust that pools investors’ money and spreads it across a range of deposits on the wholesale money markets. Cash ISAs have provided an opportunity for small building societies to enter the market, many of which are offering cash mini-ISAs and nothing else. Cash investments are the lowest-risk option. You can’t lose any capital, but you only earn interest and, after inflation is taken into account, your money is unlikely to grow much over the long term.

Stocks & shares ISAs can invest in a wide range of holdings and are suitable for medium to long-term investors who are looking for capital growth, higher income or a combination of the two. You can choose to invest in: ordinary shares, preference shares and convertibles, corporate bonds, UK government gilts (provided they have five years to run when first purchased), managed collective funds such as unit trusts, OEICs, investment trusts, and offshore funds. You can invest in any recognised stock exchange in the world.

Stocks and shares have proved a popular investment, as investors can simply use them to hold user-friendly funds like unit trusts or OEICs, which are generally considered to be the best option for novice investors. They provide an indirect way of investing in companies and generally offer exposure to the stock market at a much lower level of risk than direct shares. They are often referred to as collective funds since they pool investors’ money together and invest it in a range of companies – typically any number from 40 to 200 different stocks. In this way they can offer a very high level of diversification even to the smallest investor.

There is a huge range to choose from. You can find funds investing in corporate bonds and other fixed-interest securities. Tracker funds have low charges because they simply follow the growth in a particular market index, such as the FTSE 100.

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.

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 may become a popular home for investors’ money once the tax changes come into force. Rather than investing in bonds directly, most novice investors are steered towards corporate bond unit trusts that pick which bonds to invest in, and package the different income payments into a single regular payment.

Many stockbrokers are offering self-select ISAs where investors can select any of the investments from the list above. Multi-manager ISAs are also available. These are single funds, which provide exposure to a range of fund managers. The manager selects, monitors and replaces the managers the fund uses, in the same way as other fund managers trade stocks and shares.

The life insurance component refers to life-insurance-linked investment products, such as life company with-profits bonds. Plans must be single-premium contracts that can accept a single lump-sum deposit.

The right investment to put into an ISA depends on a number of factors: what other investments you hold, your appetite for risk, 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 costs for an ISA divide into two parts: the ISA wrapper itself and the underlying investment.

Cost for the ISA – cash ISAs build all their costs into the rate they pay. The few insurance ISAs around have no ISA charge, only charging for the underlying investment. Stocks & shares ISAs vary in their approach.

Many fund managers make no additional charge for the ISA wrapper and only levy their charges for the underlying funds. Some may make an additional charge, however – perhaps a flat fee for setting up the ISA of, say, £30, and an annual fee or an exit fee when you sell the ISA.The most likely type of ISA to levy additional charges is a stockbroker operating a self-select plan, particularly if advice is being given on which stocks and shares to buy. This is typically a flat set-up fee to establish the ISA and an annual fee, 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 – trading in shares and corporate bonds or gilts directly will incur dealing commission (from 0.5 to 1.75 per cent per deal, depending on your stockbroker). Some brokers cap charges so they cannot go above a certain level – say, £45 a deal.

Watch out for minimum levels as well. If a broker charges 1 per cent a deal, subject to a £20 minimum, the percentage cost will be higher for deals of less than £2,000. Purchases of shares also incur stamp duty of 0.5 per cent.

Unit trusts have two charges: the initial charge and the annual management fee. The initial charge, incorporated into the bid/offer spread, is typically 3 to 6 per cent and levied on each investment contribution. The annual management charge is anything from 0.3 to 1.75 per cent and is a percentage of the fund’s end value.

Around 3 per cent of the initial charge covers commission to advisers. One way round this is to use a discount broker who will rebate the commission either as a cheque or (more practical if you are investing each month) as a further investment into your chosen fund.

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 may have to pay stockbroking costs to buy and sell their shares. Shares can be bought through a conventional stockbroker. 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. Many providers have their own internet sites and will allow you to apply online.

Organisations such as the Investment Manage-ment Association (IMA) and the Association of Investment Trust Companies (AITC) can provide generic information about funds. The AITC offers an excellent Monthly Information Service, which details individual investment trusts and gives past performance figures.

Interest rates for cash ISAs should be checked regularly – check in newspapers on Wednesdays and at weekends, or in magazines like Personal Finance.

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.
Bear in mind that advisers from banks, building societies and life insurance companies are, in most cases, not independent. They are tied advisers who can only recommend the products of the company they work for. One exception is Bradford & Bingley, which does operate as an IFA.

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 the ISA – typically 3 per cent of each contribution into the ISA plus 0.5 per cent of the fund value each year – or will charge a time-based fee. IFAs are most suited to discussing unit trusts. 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 (carry out your instructions to buy and sell securities), advisory (advise on suitable holdings) and discretionary (buy and sell on your behalf).

Monthly Saving Schemes

A real boon if you don’t have much money to invest is a monthly savings scheme, which will deduct your ISA contribution straight from your bank account and invest it straight into your ISA.

The majority of fund managers now offer a monthly investment facility 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 £40.

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 should hit both the market highs and lows, rather than running the risk of putting all your money into the market when prices are high.

You can also benefit from the effects of 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.

The maximum you can invest in an ISA per month
is £583.

TRANSFERRING YOUR PEP OR ISA

Even though you can no longer invest in a PEP you can transfer your existing investment to another PEP provider if it no longer meets your needs. You can also transfer an ISA to another ISA provider if you want to. There are several reasons to consider a transfer:

• The performance of your investment is poor over the medium to long term
• Your attitude to risk has changed
• Your investment needs have changed
• The manager of the fund has changed

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 of up to 2 per cent 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 PEP offered by the same management group, as this will usually attract 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.