What is an ISA?

The taxman does not give us much for free so when he does we should grab it with both hands.

Individual Savings Accounts (ISAs) were introduced to encourage people to save and they offer attractive tax breaks for anyone looking to set aside some money for their future.

They were originally brought in by the then Chancellor Gordon Brown back in 1997 as a replacement for Personal Equity Plans (PEPs) and Tax-Exempt Special Savings Accounts (TESSAs).

An ISA is not an investment in itself but rather a tax wrapper in which you can hold a wide range of investments, including stocks and shares, cash, gilts, unit trusts and even some types of structured product.

Everyone over the age of 18 and a UK resident qualifies to take out an ISA and 16 year olds are also allowed to take out cash ISAs.

The big draw of ISAs is that any gains are free from income or capital gains tax and you do not even need to mention them on your tax return.

Despite this, millions of us fail to take advantage of our annual allowance. To try and encourage more of us to take out ISAs, the government simplified the regime and increased the amount you can save tax-free last year.

The old mini- and maxi-ISA was swept away and the wrapper made much more flexible.

Now, your overall ISA allowance is £7,200. How you use this is up to you within certain guidelines. You can invest up to a maximum of £3,600 in a cash ISA and then put the remaining £3,600 into a stocks and share ISA.

Alternatively, you could invest just £1,000 in a cash ISA and stick the remaining £6,200 in a stocks and shares ISA, or, as another option, invest the full £7,200 in a stocks and shares ISA.

The cash ISA component is exactly what it sounds like. Your money is held on deposit and will receive a set level of interest each year free of tax. Make sure you shop around for the best rate. By checking out the best-buy tables and carrying out a little research online, you will find that your own bank is often not the best payer.

In the stocks & shares ISA, you can hold a much broader range of investments. These include unit trusts and Open Ended Investment Companies (OEICs), investment trusts, direct equities, UK government and corporate bonds, some structured products, certain types of life assurance products or any combination of these assets.

This might all sound rather complicated and many of us do have a tendency to file our finances in the ‘to do’ tray and forget about them.

It is estimated that around £1 billion of ISA allowances will go unused this year but experts stress it really is worth taking the time to shelter your savings from the taxman.

Meera Patel, an investment adviser at Hargreaves Lansdown, says: “If you use your allowance every year, ISAs offer you the chance to build your own personal tax haven.

However, miss the deadline for a tax year and you lose that part of your of your allowance forever.”

It is a point worth stressing that you cannot carry your allowance into the next tax year or pass it on to anyone else. The tax year runs from April 6 to the following April 5, so if you do have spare cash lying around you can also choose to ‘double-up’ and take up both this year’s and next year’s allowance either side of the deadline.

Many experts fear that the sharp falls seen in the stockmarkets over the past two years and poorer deposit rates following the spate of interest rate cuts will deter many investors from bothering this year.

Paul Kennedy, director of tax wrapper and trust planning at Fidelity International, stresses that savers need to put aside short-term concerns and view ISAs as long-term investments.   

He says: “It’s not going to be news to anyone that an ISA is tax efficient but I do wonder how many people really appreciate just how much more an ISA can produce. With the prevailing economic conditions, my fear is that the public will undervalue the ISA allowance and let it go this year.”

Certainly, the tax savings that can be built up over time should not be sneezed at. Even with the returns paid on cash ISAs currently at the lowest level since they were launched investors will be quids in.

Kevin Mountford, head of banking at Moneysupermarket.com, points out that savers who have used their full cash ISA allowance in each of the last 10 years is already £2,700 better off than basic rate taxpayers who have saved the same amount outside an ISA. A higher-rate taxpayer would be more than £4,800 worse off.

He adds: “Inflation is on the way down and cash ISAs are paying around 3.25 per cent, so they are still a very good proposition for savers. With ISA rates halving from their high of 6.5 per cent last year, it's more important than ever to ensure your savings are working hard for you. Saving within an ISA is a no-brainer as the figures suggest - an extra £2,700 over 10 years is nothing to be sniffed at.”

The tax savings for investors in more speculative investments, such as equities, can be even more marked over time. Admittedly, the tax savings are not quite as attractive as they once were on equities.

From April 2004, Gordon Brown removed the 10 per cent tax relief on dividends from shares and now takes this direct from the fund or direct from the share dividend.

That said, all of the income from fixed interest securities and cash remains fully sheltered, while the exemption from capital gains tax remains the main draw for many.

Patel points out that the current individual capital gains tax allowance is only £9,600.

“While capital gains tax might sound like a good problem to have, it is even better if you can have the gains without the tax, and it is surprising how quickly gains beyond your allowance can be achieved,” she says.

Few would argue that more money in their ISA is preferable to more money in the tax man’s coffers and this is the key reason why you should think long and hard about not letting this year’s, or any other year’s, precious allowance slip away.