An individual savings account (ISA) is a tax-efficient way to save, with no tax liability when the proceeds are withdrawn. In addition your investment is free of capital gains tax and there is no liability for tax on any income taken from the fund.
An ISA is not an investment in itself but a 'wrapper' to shield an investment from tax – whether it is cash, bonds or equities. The tax breaks are on exit, not entry, so the investments are made using taxed income, but the proceeds on withdrawal are tax free.
Be aware however, that ISAs are not entirely tax free as tax is paid on dividends received within the fund.
An ISA can also be used as part of a long-term financial planning strategy. For example, you can transfer ISA savings into a pension at any time, thereby exploiting the generous tax reliefs on pension contributions.
Unit trusts and OEICs can often be bought more cheaply within an ISA wrapper as fund management groups often offer discounts on initial charges, particularly in the run-up to the end of the tax year in the period between January and April.
Investment limits
- For the tax year to 5 April 2012 the annual ISA limit is £10,680 for all eligible ISA investors;
- For the tax year to 5 April 2012 the annual ISA limit is £11,280 for all eligible ISA investors;
- All of it can be invested in a stocks and shares ISA. Alternatively, up to half of the annual limit can be invested into a cash ISA with one provider, usually a bank or building society, while the remainder can be invested into a stocks and shares ISA with the same or another provider;
- Cash ISAs can be converted into stocks and shares ISAs at any time.
Cash ISA
Cash is perceived as a low risk investment, and certainly there is little or no volatility in the accumulation of returns (interest), so it is an effective investment for those that have no tolerance to risk.
Remember though, there is one certainty, there will be no capital growth on the original investment, and in some market conditions the interest earned and rolled up may not counter the effects of inflation.
However, rates offered on cash ISAs are often higher than on the same institution's standard savings accounts, so this, together with their tax free status, can make cash ISAs attractive for many investors.
Most banks and building societies offer cash ISAs, but the terms and conditions vary considerably. Some accounts require a minimum deposit when an account is opened, while others can be opened with just £1.
Some allow instant access. Others have a notice period for penalty-free withdrawals, so these terms need to be checked if there is a possibility that these funds will need to be called on at short notice. Some allow transfers-in from other cash ISAs, while others do not, and some ISAs can only be managed online.
Stocks and shares ISA
A stocks and shares ISA can include most authorised unit or investment trusts, or open ended investment companies (OEICs), as well as most securities quoted on a stock exchange recognised by the HM Revenue & Customs.
Shares are viewed as more risky than cash, and are certainly more volatile in terms of performance. However, over the longer term the prospects of superior returns are much higher. Risk can be dampened by diversifying the spread of investments and/or investing on a regular basis, rather than a lump sum spread, by investing in diverse portfolio of shares or via unit and investment trusts.
Stocks and shares ISAs also known as equity ISAs are sold by stockbrokers, IFAs, fund managers, banks and other authorised financial institutions. ISAs may also be bought directly from these institutions or advice can be obtained from an independent financial adviser on where to invest.
How much do ISAs cost?
How much a stocks and shares ISA costs depends on how and where it is bought and the underlying investment.
The vast majority of ISAs come with initial and annual management charges.
The initial charge on investment funds placed within an ISA can range from 0-5%, although many firms offer discounts of up to 3% off initial charges. The annual management charge is typically between 0.5% and 2%, depending on the type of fund selected.
Individual shares purchased for an ISA are subject to standard stock broking charges, which are typically between £10 and £25 for these types of transactions. In this situation the ISA wrapper is likely to levy an annual administration charge of up to 0.5% per annum.
Financial advisers
It is recommend that advice is sought before committing to an ISA investment, particularly stocks and shares ISAs. Independent IFAs will have researched the market and be able to guide you on which of the thousands of investment options are most suitable, based on quality and your own tolerance to risk.
It is also likely that an IFA will have negotiated discounts on the charges.