The rules for Individual Savings Accounts (ISAs) have changed this tax-year, so I thought it was time to review this valuable tax-avoidance scheme.
ISAs are little more than an official tax-wrapper into which other investments may be hidden from the tax-man. Each tax year every adult has an allowance of 7,200, increased from 7,000 last year and cash, shares, unit-trusts and investment trusts may be held inside this tax wrapper. Cash is treated differently to other investments in that there is a maximum of 3,600, up from 3,000 last year, but if you use the cash allowance, the remainder may be made up of the other types of investment.
Apart from the increase in allowance from 7,000 to 7,200 (and 3,000 to 3,6000 for cash ISA) the other changes are that now any money held in a cash ISA may be transferred to the equity part of the ISA at any stage in the future. Previously ISAs were far more complicated and you had to either opt for, up to 7,000 in a "Maxi" Equity ISA, or up to 3,000 into a Mini Cash ISA and up to 4,000 in a Mini Equity ISA and then you were stuck with that forever (although Cash ISAs from previous years may also be transferred now) There is a catch however: You cannot move the money back to a Cash ISA at a later stage. You can however keep cash in the equity part of the ISA, but it must be for future investment and is not tax-free. Overall ISAs are now simpler and slightly more useful.
Equity ISAs are not completely tax-free, but they are better than almost anything else on the market. Cash ISAs are completely tax-free, in that all interest is paid gross, although you have to check the rates are competitive, because you probably don't want to keep moving your money. The Equity part of the ISA is more complicated in that payments from bond funds (corporate bonds or gilts) are classed and interest and therefore tax-free, whereas true equity investments (such as share funds, investment trusts; OIECs and unit-trusts) no longer have the dividend tax credit refunded, so tax on company dividends, which are taxed at source, cannot be reclaimed by the ISA to make them truly tax-free (this is complicated and not understood buy most, so Gordon Brown removed this in one of his many "stealth" taxes) This is effectively a 10% tax on dividends.
ISAs are capital gains tax (CGT) free, although there is a personal allowance for CGT of 9,600 for 2008/2009 which means there is no tax advantage unless you are a 40% tax payer, or you are going to make a significant capital-gain.
The cash ISA makes a lot of sense for most people, especially those paying 40% tax, as long as you can get a good rate of interest, as there is no tax on interest. The reason to bother with an Equity ISA, is in time, you really could be hitting the CGT allowance, if you keep trickling money in over many years and don't dip into the fund. You also won't have to worry about declaring gains or dividends and of course, if you do pay 40%, it makes a huge difference, because an additional dividend tax would otherwise need to be paid. If you don't use your annual allowance, you will lose it and in general it is no more expensive to hold investments inside the ISA than outside. Investing in corporate or government bonds is still tax-free inside an ISA and also makes a lot of sense for everyone (they are generally safer than shares, but over the long term tend to pay out less)
You can invest in unit-trust, investment trusts or individual shares. Investment trusts are shares in investment companies and generally have lower charges and better performance than unit trusts, which are often recommended by advisors. Investment trusts do not pay commission to advisors, so they are unlikely to recommend them. There are hundreds of investment trusts and thousands of unit-trusts to choose from, ranging from UK larger companies or low-risk bonds to emerging markets and Japanese smaller companies, gold, mining and commodities. If buying unit-trusts for your ISA it is best to buy the ISA from a "fund supermarket" or discount broker, who will return most of their commission in the form of a discount. Individual shares are riskier and should be treated with care. It can also be expensive in charges to build up a diversified portfolio of individual shares.
If the organisation with which you have you Cash or Equity ISA goes bust, what happens to the money? Cash ISAs are covered under the 35,000 Financial Services Compensation Scheme (FSCS) and are treated just like an ordinary cash account. With an Equity ISA 50,000 is covered. 100% of the first 30,000 is covered then 90% of the next 20,000.
I certainly think ISAs are a good idea. Probably the best deal you can get for equities and definitely for bonds. Equity investment is risky, but no more risky in an ISA than outside. As for cash, NS and I index-link savings certificates at the moment give a possibly better return than a cash ISA, although this is more restrictive, but for most people Cash ISAs are an extremely good deal too.