ISAs have hit the headlines in recent weeks, with Prime Minister Gordon Brown hinting the forthcoming Budget may include changes to make tax wrapper more attractive.

This comes on the back of significant developments in the ISA world in 2008, when the Government also confirmed a long-term future for the product.

While ISAs started life in 1999, the story of tax wrappers goes back to 1987, when Conservative Chancellor Nigel Lawson introduced Personal Equity Plans to encourage more people to invest in the stock market.

The basic incentive behind all these wrappers is that all the income and capital gains from the investments is tax-free.

PEPs were first unveiled in the 1986 Budget and initially focused on individual shares.

Lawson wanted to build on the programme of privatisation issues the government was engaged in at the time, with the aim of expanding individual share ownership and encouraging investment in UK industry.

Initially, there was something of a bias against collective investment funds.

At outset, the limit on Pep investment was set at £2400 with various restrictions on when money could be withdrawn.

Over the years, a number of changes were made to make PEPs more attractive to investors, such as increasing subscription limits and the proportion allowed in funds, which ultimately got up to 100 per cent.

For a while, there was also the opportunity to make extra contributions to a separate single-company PEP each year, in addition to your main wrapper.

By 1990, the Chancellorship had passed to John Major, who introduced another tax-free savings vehicle, the Tax-Exempt Special Savings Account (TESSA).

These were designed as a balance to the equity-orientated nature of PEPs, allowing cash to be invested in TESSA-designated deposit or share accounts, generally operated by banks or building societies.

When Labour came to power in 1997, they recognised the success of the vehicles and introduced their own ISA two years later.

The idea was to build on the positive aspects of PEPs and TESSAs but to broaden their scope and encourage a wider range of people to make long-term savings.

As part of the changeover, no new PEPs or TESSAs could be opened after 5 April 1999 but existing plans were allowed to continue.

While TESSAs had a fixed life of five years and had to be cashed or rolled into a TESSA-only ISA when they matured, PEPs continued to operate until the rules were aligned last year.

Under these changes to ISA rules, the limit increased for the first time since launch, rising to £7200, with further increases potentially on the cards.

Other developments included the ISA and PEP regimes merging and the removal of Mini and Maxi Isa distinctions (for more details, see the What is an Isa? section).

TOISAs were also abolished, becoming cash ISAs.

As evidence of the long-term sustainability of ISAs, recent research from Fidelity International reveals investors can potentially double returns by moving holdings into the wrapper.

An investment can grow around 67% more in an ISA for higher rate taxpayers and in some cases growth could be over 100% higher

Lower tax rate payers can see a 25%-30% boost to their return

Paul Kennedy, director of tax wrapper & trust planning at Fidelity, says: “With the prevailing economic conditions, my fear is that the public will undervalue the ISA allowance and let it go this year.

This is why we feel it is a good time to put some substance behind the term tax-efficient. I want people to understand just how much money they could be throwing away if they don’t use the allowance. Even where someone has no new money they should look at transferring existing investments into an ISA.”  

Onshore bonds, offshore bonds and collectives all have different tax treatments that apply different tax rates to different asset classes.

For example, a higher rate taxpayer receiving £100 interest would see £36 deducted in tax if it was held in an onshore bond and £40 if it was held in an offshore bond or collective investment. There would be no deduction from an ISA.

According to Kennedy, ISAs simply produce a higher return from exactly the same underlying investment.

In the case of a higher rate tax payer holding an interest bearing onshore Sterling corporate bond fund for example:

• An ISA wrapper will immediately see a 67% higher return compared to a collective.
• A 56% higher return compared to an onshore bond.
• A 67% higher return compared to an offshore bond.

Kennedy adds: “We can safely say every single investor is likely to be better off by putting their non-pension assets in an ISA than they would if they used any other tax wrapper.

Investors with new money but who don’t wish to invest at this time could consider parking the money in cash so as not to lose the allowance. If they have no new money then they could transfer existing investments into an ISA.

If all else is equal, it would seem almost indefensible not to consider moving assets from an existing wrapper into an ISA. As a rule of thumb, investors might consider whether existing non-pension investments should ever be left with an unused ISA allowance.”

ISAs for savers