Thanks to the currently high rate of inflation, the 2012 ISA allowance has been increased quite a bit above last year’s level.

The 2012 ISA allowance is £11,280.

This means that between 6 April 2012 and 5 April 2013, you’ll be able to put up to £11,280 into your ISAs – and so out of the reach of the taxman!

Note: The ISA allowance is the amount of new money you can put into an ISA over the year. If you already have ISAs with funds in them from previous years, that money doesn’t count towards the new annual ISA limit. Only new money does. This way you’re allowed to build up an ever-bigger ISA pot over time.

As always, up to 50% of your total ISA allowance can be put into a cash ISA. This means the 2012 cash ISA allowance is £5,640.

The total you can put into a stocks and shares ISA is £11,280 minus whatever you will put into a cash ISA that year.

For instance, if you choose to put £2,000 into a cash ISA over the 12 months to 5 April 2013, then you could put £9,280 into a stocks and shares ISA that same tax year.

On the other hand, if you don’t put any money into a cash ISA, then you have the full 2012 ISA allowance free for shielding more of your equities and bonds from tax by moving them into an ISA1.

How to use your ISA allowance

Only higher-rate taxpayers pay tax on share dividends, whereas income from cash, corporate bonds and gilts is taxed for lower rate and higher rate taxpayers alike.

This means most lower-rate tax payers owning bonds should put them in an ISA first, and then put dividend paying equities in after that if they have any spare ISA allowance leftover.

Higher rate taxpayers should put whatever they can into an ISA. You might put your highest yielding shares or bonds into an ISA first, to protect the income they pay from tax. (The effective tax rate on share dividends is lower than on bond income, though, so do your maths).

Even if you’re a lower rate taxpayer and you own no bonds, I’d still put your shares (whether directly owned shares or shares held in an index fund or similar) inside an ISA wherever you can.

This is to avoid you building up a capital gains tax time bomb, which can really take the shine off selling your shares for a profit in a few years time!

What’s more, you might become a higher rate taxpayer in the future.

2012 ISA allowance and CPI inflation

The ISA allowance only began going up with inflation in March 2010, when the government raised the annual allowance by £3,000 to £10,200 for the 2010-2011 tax year.

At the same time, the then-chancellor Alistair Darling also announced the annual ISA allowance would go up every year by the RPI inflation rate in September of the prior year, rounded to the nearest £120.

However no government seems to like allowing us to pay less tax, especially in times of austerity. Accordingly, the current chancellor George Osborne is only raising the 2012 ISA limit by the CPI inflation rate, which is typically lower than the RPI inflation measure.

CPI inflation was 5.2% as of the official September figures. RPI inflation was running at 5.6%!

At least the rounding procedure has worked in our favour.

The 5.2% inflation rate should have meant the new limit was £11,235. But rounding to the nearest £120 takes us higher to £11,280.

Monthly savings into an ISA

Rounding to the nearest £120 is designed to make it easier for us to set up monthly savings.

Dividing the 2012 ISA allowance by 12 months gives us a saving target of £940 a month, which is quite a substantial amount for most people to save from their earnings.

One way to use it up is to sell any non-ISA-d investments that you’ve got that can be moved into an ISA. (I’ve been doing this for years, having foolishly not bothered with ISAs (or their predecessors, PEPs) in my early years of saving).

If you’re thinking of funding your 2012 ISA allowance with share sales, then read my article about defusing capital gains tax on shares for some pointers on how best to sell.

1. Note that when I speak of moving shares and bonds into an ISA here (and in the rest of the article) I mean selling them, putting the money raised into an ISA, and then repurchasing. Unfortunately you cannot transfer shareholdings into an ISA directly to avoid these transaction costs. [↩]

We’ve seen how index funds are usually preferable to ETFs when it comes to simplicity and costs. But does either passive approach have the edge when it comes to tracking the underlying index?

Low costs are a honeypot for passive investors, but paying a low Total Expense Ratio (TER) means nothing if you don’t reckon for tracking error.1

It is a tracker’s job to hug its benchmark index tighter than long-lost octopi twins. Tracking error (also known as tracking difference) can show us how well any index fund or ETF is doing that job.

Check tracking error for any passive fund

An initial saving on TER can soon be wiped out by a misfiring tracker that deviates wildly from its index.

So if you’re picking between a rival index fund and an ETF on the basis of TER, it’s worth also checking whether their respective tracking error makes the low TER a false economy.

If there’s little to choose between them on a TER basis, then I’d personally go for the tracker with the lower tracking error.

Note that synthetic ETFs are reputed to have a low tracking error due to their unique fund structure. However, they are currently subject to a great deal of regulatory heat and media controversy. Make sure you understand the particular risks of synthetic ETFs before taking the plunge.

In terms of index funds versus ETFs, I’m calling this one a draw. While synthetic ETFs may have an advantage when it comes to tracking error, they also introduce a can brimming with worms that I’d rather avoid when passive investing.

In part 4: Which type of tracker offers the most choice?

Take it steady,

The Accumulator

1. Note that we have used the term tracking error throughout this post, because that is the term most of the world uses to describe how much a tracker strays from the return of its benchmark index. However what is commonly termed tracking error is more properly called tracking difference. Tracking error is specifically a mathematical measure of standard deviation. In practice the terms are fairly interchangeable, unless you are a quant analyst by profession! [↩]

Some good reads from around the Web.

I have dug up an extra great list of links this week, so just a brief intro via a graph from Business Insider, showing one crazy day in Greece.

In normal times I’d argue that equating broad stock market moves with micro-political developments in a country worth 1% of European GDP was risible.

But these are not normal times – I was watching the markets closely on Thursday, and I watched it happen:

Of course, it’s much better to ignore the markets and your portfolio for months at a time. Short-term volatility doesn’t matter when it comes to long-term returns.

[continue reading…]