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INTRODUCTION

It’s ISA season again, a time to tinkle with your finances so that you get to keep as much of your savings in your pocket – and out of the taxman’s grubby mitts – as possible. ISAs have proved to be immensely popular with UK savers since their inception almost 10 years ago, with an incredible £207 billion locked into these tax-safe wrappers, an amazing figure when you think about it. However, getting the most from ISAs takes a bit of knowledge and understanding, and that’s where this ISA special will come in very handy indeed. Taking you through the basics, the rule changes that will come into force in April, plus an assortment of technical and tactical information, this is just what you need to keep the taxman’s clutches off your valuable savings and investments. Happy, tax-free investing.

Steven Frazer, Editor

CHOOSING AN ISA

Individual Savings Accounts, or ISAs, were first introduced back in 1999 and the government has recently made them a permanent feature of the savings landscape. An ISA is not an investment in itself, but rather a tax-free wrapper into which it’s possible to contribute a maximum of £7,000 in the current tax year. From April 6 this is increasing to £7,200.

ISAs have proved incredibly popular and have allowed investors to accumulate over £207 billion of assets safe from the taxman. Those who have yet to top up their accounts still have time to do so before the April 5 deadline, but it’s important that they act quickly given the ‘use it or lose it’ nature of the allowance. This will be less of an issue for investors who see the recent stockmarket falls as a long-term buying opportunity, but anyone concerned can simply invest somewhere safe like cash or bonds and then switch when they feel confident enough to do so.

The first decision that investors need to make is which type of Individual Savings Account would suit them best. Anyone who just wants to keep their money in cash and earn a tax-free rate of interest should open a cash ISA, whereas those who are prepared to invest will need to take the stocks and shares option. 'The stocks and shares route is for money you're prepared to keep invested for a minimum of five years, it’s not an emergency money fund,' says Corey MacEachern, managing director, NatWest Stockbrokers. The latter is available in the form of either a managed fund ISA or a self-select ISA. 'If you are comfortable with stock market investing – perhaps you already own some shares or have a SIPP – a self-select ISA could be worth considering,' MacEachern says. 'As the name suggests, you choose each and every investment you want to hold. This gives you full control and responsibility over asset allocation and risk profile.' On the other hand, a managed fund ISA has the convenience of simply choosing an 'off-the shelf’ package that meets your risk and reward expectations. All you need to do is make your payments and leave the rest to the professionals.'

1.1 Managed fund ISAs

When an investor buys a professionally managed fund within an individual savings account it is referred to as a managed fund ISA. These can either take the form of a unit trust, an open-ended investment company (OEIC), or an investment trust. The main reasons for choosing a managed fund are that it offers greater diversification and allows people to benefit from the expertise of a professional investment manager.

Managed ISAs are normally available direct from the relevant fund management company. The problem with this is that investors are only likely to be able to choose from the limited number of in-house funds. Buying direct can also work out more expensive, unless the company offers a full or sizeable discount on the initial charge.

The more popular alternative is to invest via a fund supermarket such as Fidelity’s Fundsnetwork(www.Fidelity/

Fundsnetwork.co.uk) or Bestinvest (www.bestinvest.co.uk). Those who may also want to hold individual shares and other investments will find similar facilities available from self-select ISA providers such as Selftrade (www.selftrade.co.uk) and Hargreaves Lansdown (www.h-l.co.uk).

The advantage of this option is that it typically offers a wide choice of more than 1,000 funds from 50 or more different companies, with investors able to mix and match. Initial fund charges that can be as high as 5% are often completely discounted, making a £350 saving on a full £7,000 investment. It is also possible to cheaply switch holdings with all the details displayed in a single consolidated account.

Over time, the most important element of the cost of a managed fund is the annual charge. This is deducted automatically from the unit price and acts as a drag on performance. Some funds and sectors are more expensive than others, but ultimately investors need to decide which will deliver the best returns at an acceptable level of risk.

1.2 Self-select ISAs

Those comfortable making their own investment decisions are likely to prefer the greater freedom and flexibility of a self-select ISA. These are basically tax efficient wrappers around standard broking accounts, with the investor able to pay in his or her annual contribution and then buy and sell at will from the wide range of assets permitted by HM Revenue and Customs.

The list of qualifying investments is extensive and covers the main areas of popular demand. This includes: individual UK and overseas shares listed on any recognised exchange, most managed funds, as well as fixed-interest securities like government gilts and corporate bonds. The principal exclusions are shares listed on AIM and the PLUS markets.

Self-select ISAs are available from stockbrokers, with the most popular providers including the likes of NatWest, Selftrade, The Share Centre, iDealing and Barclays.

Chris Stevenson, associate director at Barclays Stockbrokers, says that investors should choose an ISA that offers a wide range of investment products. ‘The inherent flexibility of the ISA allows a client to achieve their investment goals – whether conservative or aggressive – with the added benefit of tax efficiency. We’ve seen some ISA investors using the recent market downturn as an opportunity to add to their equity portfolio, while others stick to a more conservative strategy, opting for funds and a mix of capital protected products.’

Investment flexibility

One of the beauties of a self-select ISA is that it’s flexible enough to accommodate different objectives. For example, young investors who are willing to accept a high level of risk may want to actively trade UK and overseas stocks. Later in life, however, they may prefer the more hands-off approach offered by equity-based funds. When nearing retirement they can then switch into fixed interest to generate a tax-free income to supplement their pension.

When looking for a self-select ISA it is important to check the range of investments on offer as not all providers support the full permissible list. One of the most important aspects is having access to managed funds, with some of the best providers in this respect being Hargreaves Lansdown, NatWest, Barclays and Selftrade.

Stephen Barber, product manager at Selftrade, says that a self-select ISA allows investors to pick and choose the exact funds that they want. ‘They should aim to build a balanced portfolio, which means looking at where a fund invests, its past performance, the charges and how it fits in with their other holdings.’

Selftrade negotiates with the investment management companies and wherever they receive a discount on the fees they pass them on to their clients. This means that they are able to offer 200 funds with a fully discounted initial charge and more than 800 funds where it is less than 0.5%.

Costs

Few self-select ISA providers levy any kind of charge for opening an account, but there will typically be an annual management fee. In some cases this is based on the value of the assets, but it is becoming more common for it to be set at a flat rate, which works out better value for those with larger portfolios. Some of the cheapest options include iDealing.com, which charges a flat £5 per quarter and Selftrade, with its annual fee of £25.

For investors who buy and sell shares the more significant cost is the dealing charge, which they incur every time they make a trade. Often the best option in this situation is to choose a provider with a fixed level of commission. One of the cheapest on the market is The Share Centre, which charges £7.50, but iDealing.com is also good value at £9.90.

The IFA AWD Chase de Vere runs a free online comparison of all the different costs charged by the major self-select ISA providers (visit www.moneycentral.moneyextra.com/selfselectis.

The biggest cost of share trading is normally the bid-offer spread and this is also the hardest element to quantify. Active traders and those who trade in large size are likely to be able to save a significant part of this by opting for Direct Market Access (DMA). This allows experienced traders to bypass the market spread and place their orders directly on the central limit order book of the stock exchange.

‘iDealing.com is currently the only company to offer Direct Market Access via a self-select ISA,’ says Foster Bowman, the company’s managing director. ‘The savings this generates are absolutely incomparable to the other trading costs.’

1.3 How to switch providers

Anyone who is unhappy with their existing ISA or who wants to consolidate their accounts together can easily transfer to another provider. The key is not to close the current plan and then use the proceeds to open a new one, as this would actually count as a withdrawal. In this situation the re-investment would be restricted to the maximum annual ISA allowance with any surplus funds losing their tax-free status.

Bowman says that to avoid this the transfer must occur directly between the two ISA managers. ‘As a minimum the investor should contact the broker that they want to move to, they may also need to speak to the one they are leaving. It is then simply a case of signing the relevant documents and leaving it to the managers to sort out.’

The rules stipulate that anyone who wants to transfer the money they have put in during the current tax year must move all of it. Partial transfers are permitted in respect of earlier years, although it is important to check the terms and conditions to see whether the existing ISA provider has imposed any restrictions on this.

‘There is normally a charge for each line of stock transferred, as well as a flat fee for the process and an exit fee,’ says Bowman. ‘We have a special offer at the moment whereby we will credit the commission costs of investors who transfer to us. Someone who moves five lines of stock across would thus get £50 of free commission.’

THE TAX BENEFITS OF INVESTING IN AN ISA

The main advantage of investing in an ISA is that any gains are free of capital gains tax (CGT). It has been argued that as everyone is entitled to an annual exemption covering the first £9,200 of gains this isn’t necessarily worth a great deal. The truth of the matter is that it all depends on the level of contributions and the investment success.

Someone who has paid in the maximum annual ISA allowance of £7,000 since these accounts first became available in 1999 may well have built up a portfolio worth in excess of £100,000 by now. Anyone in this position will have already found the CGT exemption to be extremely valuable and with ISAs now a permanent part of the savings landscape lots more are set to benefit in the future.

MacEachern says that the key tax advantages are that there is no capital gains tax and no income tax on the proceeds of an ISA. ‘In addition, investments held within the ISA grow largely free of income tax. There is a 10% tax credit on dividends that cannot be reclaimed, but for higher rate tax payers there is no further income tax liability.’

ISAs do not have to be declared on the annual self-assessment tax return so there is no need to complete any of the associated CGT calculations, which is a fair benefit in itself. The only downside is that any capital losses made within an ISA cannot be offset against gains made outside.

For income seekers the tax position depends on the nature of the asset. Those who invest in fixed interest securities or corporate/government bond funds will find it highly advantageous to shelter them within an ISA. This is because the plan manager can reclaim the 20% tax deducted at source from the interest payments. The same also applies to holders of Real Estate Investment Trusts in respect of the 22% tax on the property income distributions.

The situation is different for basic rate taxpayers who invest in UK company shares and equity-based managed funds, since the tax treatment of dividends is the same irrespective of whether these assets are held inside or outside of an ISA.

The anomaly is that for higher rate taxpayers there is still a major advantage in holding shares within an ISA. This is because they do not have to pay the higher rate tax on dividend income that they otherwise would. For example, the annual after tax income on a £7,000 investment in equities paying a net yield of 3.5% would be £245 if held in an ISA and just £183.75 (three-quarters of the amount) if not.

Income distributed from an ISA does not have to be declared on the end of year tax return and this can mean savings in some of the age-related allowances. Those over 65 for example are entitled to a higher personal allowance, though this is progressively reduced by £1 for each £2 of excess income over £20,900 until the basic allowance is reached. Investing via an ISA means any income from these holdings is ignored in this calculation and hence the higher allowance doesn’t get clawed back. The same principle also applies to the married couples allowance for those over 73.

THE CURRENT CONTRIBUTION RULES

Individual savings accounts are available to anyone who is over 18 and resident, or ordinarily resident, in the UK. The rules are changing at the end of the tax year, but until midnight on 5 April the annual ISA allowance remains £7,000. This can either be paid into a single Maxi ISA or spread across two separate Mini ISAs.

A Maxi ISA allows an individual to hold all £7,000 in stocks and shares, or they can limit this to £4,000 and put up to £3,000 in a separate cash component, assuming that the plan manager offers this dual facility. Only one Maxi ISA can be opened in any given tax year and doing so would rule out the option of subscribing to a Mini ISA during the same period.

Investors who forego a Maxi ISA can instead open a Mini cash ISA and/or a Mini Stocks and Shares ISA. The investment limits are £3,000 and £4,000 respectively and each component can be opened through a different provider if so desired. Mini cash ISAs are also available to those in the 16 to 18 age bracket.

It is important to remember that these are all hard and fast limits. This means that an investor who pays in the maximum amount but then decides to withdraw some of the money would not be allowed to re-invest it in the same tax year.

HOW TO TAKE ADVANTAGE OF THE NEW RULES

New rules are coming into effect on 6 April this year which will affect all 17 million investors in this country with an ISA. The changes are intended to make these tax efficient accounts simpler and more flexible to use.

‘The changes are good news for investors,’ says MacEachern. ‘For a start, the distinction between Mini and Maxi ISAs will be removed. For the 2008/09 tax year investors will also have a higher ISA allowance of £7,200 and at last, all PEP accounts will automatically be reclassified as Stocks & Shares ISAs, which will come as a welcome relief to those investors who have both.’

The removal of the distinction between Mini and Maxi ISAs will save a lot of confusion. Under the new regime investors can either opt for a Cash ISA, a Stocks and Shares ISA, or a combination of the two. This more flexible arrangement will allow people to save up to £3,600 in cash with one provider, while investing the remainder of their £7,200 annual allowance in stocks and shares with either the same, or a different provider.

As from 6 April all existing accounts are to be reclassified to tie in with the new rules. This will mean that Mini Cash ISAs, TESSA Only Individual Savings Accounts and the cash component of a Maxi ISA will all simply become ‘Cash ISAs’. In the same way, Mini Stocks and Shares ISAs and the stocks and shares component of a Maxi ISA will both just be known as ‘Stocks and Shares ISAs’.

The changes will also affect the 3.5 million Personal Equity Plan holders. PEPs were the forerunner to ISAs and although it hasn’t been possible to make any new contributions since 1998/99 there is still a considerable amount of money built up in them. From 6 April these accounts are to be reclassified as Stocks and Shares ISAs.

‘The distinction between PEPs and ISAs will disappear and where a client holds both types of accounts we will consolidate them together,’ says Barber. ‘This will provide an ideal opportunity for investors to review their overall portfolios.’

Perhaps the most significant change is that from the 6 April onwards it will be possible to transfer money from a Cash ISA to a Stocks and Shares ISA. Those who have built up considerable cash savings may want to take advantage and rebalance their portfolio, especially as interest rates are expected to come down. A transfer like this would not count towards their annual ISA allowance, but they should bear in mind that it is a one-way arrangement and cannot be reversed.

WHERE TO INVEST THIS YEAR’S ISA ALLOWANCE

The most critical aspect of an ISA is deciding where to actually invest the money. When considering the options the key is to focus on the impact on the overall portfolio, especially with regards to the level of risk.

Short-term risk avoidance

The ‘use it or lose it’ nature of the annual ISA allowance means that anyone who fails to make their contributions by midnight on 5 April will have missed the boat for this financial year. For those concerned about the short-term prospects, the simplest solution would be to open a self-select ISA but keep the money in cash until the outlook improves. Where available, a money market fund would provide a better a rate of interest.

‘Investors who fund their self-select ISA can ensure they use their full ISA allowance,’ says MacEachern. ‘The £7,000 will then sit in a cash management account awaiting their instructions on how and when to invest in the stock market.’

Those prepared to take a little extra risk could temporarily invest in either a fixed interest or a multi-asset class cautious managed fund. The alternative would be to put up to £3,000 into a Mini Cash ISA and then transfer the money to a Stocks and Shares ISA sometime after the new rules come into effect on 6 April. See www.moneyfacts.co.uk for the best rates of interest.

Those who want to press ahead with a stock market-based investment could limit the risk by using a provider that accepts regular monthly contributions, or by choosing a capital protected fund.

Investing for the longer term

Most self-select ISAs operate on an execution-only basis with account holders having to make their own investment decisions. The majority of companies do as much as they can to help by providing a wealth of online research. For example, those interested in stock recommendations, news and analysis will appreciate the extensive resources provided by the likes of NatWest, Barclays and The Share Centre.

Ian Benning, product development manager at The Share Centre, says that it is unusual for an execution-only broker as it has its own advice team. ‘Clients can ring in and get a second opinion on a stock or be recommended an alternative in the same sector. There is no extra cost for this service and our website also has buy, sell and hold recommendations on each of the FTSE 100 constituents with notes on why we have come to that conclusion.’

There is more help available when it comes to selecting investment funds. In fact most ISA providers are pretty good in this area, although it is hard to beat the extensive research from Hargreaves Lansdown. Investors looking for an off-the-shelf solution may also appreciate a ready-made fund package like those put together by Barclays Stockbrokers.

‘We often get feedback from clients that understand the benefits of investing in funds but feel overwhelmed by the choice available,’ says Stevenson. ‘The purpose of the packages is to provide a simpler funds investment choice, aligned to a clear investment strategy.’