This is the first in my special five-part series entitled Five big boring tax changes that will make you richer or poorer in 2008/09. For the others, please see the introduction to the series [1].
From April 6th 2008, ISA rules for UK residents change as follows:
- Your annual total ISA allowance rises to £7,200, and the stupid ‘maxi’ and ‘mini’ ISA distinction is abolished.
- Instead, you can get a cash ISA and/or a Stocks & Shares ISA.
- You can invest from £0 to £3,600 in a cash ISA during the year, and the balance (up to your total of £7,200) into a Stocks & Shares ISA.
- Personal Equity Plans (PEPs) held from the 1990s are reclassified as Stocks & Shares ISAs.
- You will be able to convert cash ISAs into Stocks & Shares ISAs in the future, but not vice-versa.
Why you should use ISAs to save tax
ISAs (Individual Savings Accounts) are a UK investor’s best friend – arguably better than personal pensions. You can hold loads of different types of assets in them, including shares, cash, investment trusts, unit trusts, and bond funds, and you don’t have to pay extra tax on the income you receive in them. Nor do you pay on capital gains on investments held in an ISA when you sell.
It’s important to realise that the ISA is effectively just a ‘wrapper’ that goes around normal investments. So while various institutions will try and sell you their Big Financial Company A ISA or the Company B Super Cash ISA, there will be an underlying investment that you’ll need to evaluate. This investment will usually be either cash, shares, bonds, or some combination, or else it will be a more exotic (and less transparent) fund that uses financial wizardry known as derivatives to (reputedly) ensure you get your capital back plus a measure of stock market growth.
Some examples of ISA products are:
- A bank’s ISA cash savings account, offering say a 6% tax-free interest rate
- A choice of the bank’s own stock market funds, with their particular aims and charges you’ll need to investigate
- A ‘Guaranteed Equity Bond’ wrapped inside an ISA (these are the vehicles that typically promise to protect your capital while returning a certain amount of stock market growth).
- An ISA wrapper around a selection of funds, as offered by the fund supermarkets, or specialists like Legal and General
- A self-select ISA, which you open with your stockbroker and can trade eligible shares within, just like any online dealing account
Should you choose a cash or Stocks and Shares ISA?
If you’re nervous about the stock market or will need the money back in the near-term, the £3,600 you can put into a Cash ISA is a handy break, since normal non-ISA cash savings are currently eroded by tax to below the rate of inflation. A tax-free savings rate of 6% is the equivalent of a 10% interest rate on a normal bank account for higher rate taxpapers.
Ideally though, it’s best to load up ISAs for the long-term and invest in the stock market, as this is when you’ll really start to benefit from not paying Capital Gains Tax and so on.
Indeed, it’s possible to build up huge sums by diligently using your ISA allowance each year on investing in the stock market and never removing any money. The FT columnist John Lee revealed a year or two ago that he’d built up an ISA and PEP fund of over £1million over 15 years, by making sure he used his full allowance each year and investing wisely.
The tax breaks on £7,200 might not seem like much, but on £1million they could conceivably stretch into six figures, especially once you take the compound interest effect on dividend income and capital growth into account. If you’re going to invest over the long-term, you must use an ISA!
Cash ISA tips
If you’re only a cash-only saver at present, look for a high interest rate, and make sure that if the interest rate becomes less attractive in the future, you are able to move your money to a new provider without closing down the ISA. You must avoid removing money from ISAs wherever possible, as once removed you cannot put that tranche of money back in.
For example, say you’d opened a Cash ISA in 2004 with £2,000 and it had grown to say £2,100. If you remove any portion of that money to spend, you can’t subsequently top it back up. New money would have to go into the an ISA for the current financial year, subject to your annual ISA limit of £7,200.
Stocks and Share ISA tips
There’s a huge variety of these available, so you’ll need to do some homework before investing.
Personally, I think most financial providers’ own ISAs are too murky, and prefer to use self-select ISAs to buy shares and funds directly through a stockbroker. This way I don’t have to pay any extra charges except a flat fee for the broker to hold all my ISAs, nor do I risk a shoddy performance from Company A or B or whoever is managing a particular fund.
A great compromise offering the best of both worlds for most investors is to hold index trackers within ISAs. Virgin Money and Legal and General are two companies that offer good, cheap index trackers within ISAs. Like this, you benefit from the long-term rise of the stock markets you track, without any huge effort on your part and without paying big fees. And because the tracker is in an ISA, the gains will be tax-free when you come to sell.
For more on ISAs, try this Guardian article [2] or What Investment‘s ISA page [3]. Or you can see the Government’s own Tax information page [4].
For more articles like this, please subscribe to Monevator [5].