ISA: The pick and mix tax-free investment

You can save cash without paying tax. Rob Griffin explains the jargon

Individual savings accounts (ISAs) should be the first port of call for anyone with cash to save because they are the simplest way of making money without having to share the proceeds with the taxman.

An ISA is effectively a wrapper within which you can place a variety of investments - principally cash, stocks and shares - safe in the knowledge that you won't have to pay income or capital gains tax on any returns generated.

Rachel Thrussell, head of savings at Moneyfacts.co.uk, believes it's important that people use as much of this annual allowance as possible.

"Everyone should have an ISA because the interest earned is tax-free and getting something from the government these days is difficult," she says.

"Even if people can only put away a couple of hundred pounds a year, every little helps."

YOUR OPTIONS

ISAs, which were first introduced by the government back in April 1999, fall into two camps: cash ISAs and stocks and shares ISAs. Cash ISAs are tax-free savings accounts offered by most banks and building societies. Interest is paid on a regular basis and your investment is guaranteed not to lose any money. Stocks and shares ISAs invest in assets such as open-ended investment companies, investment trusts, gilts and shares. The value of your investment can fall as well as rise.

EXISTING RULES

You can invest up to £7,000 within ISAs during any tax year. Under the current regime, you can either place the full amount in a stocks and shares ISA or split your allocation with up to £3,000 going into a cash ISA and a maximum of £4,000 in a stocks and shares product. You can either put in lump sums or make regular contributions, depending on your circumstances.

There aren't any time constraints governing ISAs. Investors can withdraw funds at any time without affecting their tax privileges. However, the maximum investment limits still apply - regardless of how much money is taken out during the year.

MINI AND MAXI ISAS

Adding to the confusion, you will also have to choose between mini ISAs and maxi ISAs - at least until the rules change next year, as you are not allowed to invest in both within the same tax year.

A mini ISA can hold either cash or stocks and shares - not both. Only one of each kind of mini ISA can be taken out each year - either from the same or different providers.

A maxi ISA can invest in both cash and stocks and shares. Although no more than £3,000 may be invested in the cash part of such a product, the entire £7,000 can be invested in stocks and shares if that's your wish. Investors are entitled to take out one new maxi ISA each year.

RULE CHANGES

Changes to simplify the ISA landscape are due to come into force in April 2008. The mini and maxi distinctions will be scrapped, although the overall limits of £7,000 will remain in place. Investors will also be able to transfer money held in a cash ISA into a stock and shares ISA and, in the future, 18-year-olds will be able to roll their Child Trust Funds into an ISA to continue benefiting from tax-free growth.

What to consider when choosing a cash ISA

* Access: Do you operate the account by going into a branch, by post, over the telephone, via the internet or a combination of ways?

* Transfers: Some institutions won't accept transfers from other ISA providers, while some will penalise you for transferring out of their schemes.

* Minimum balance requirements: A number of providers insist on minimum amounts being put in for you to open an account.

* Cash cards: Some institutions provide cards with which you can withdraw cash from the ISA account.

* Withdrawals: There could be a limit to the number of withdrawals that you can make before losing interest - or having the account closed.

* Bonus rates: Some ISAs that appear to offer very attractive rates of interest may be including a bonus rate that only applies for a certain period, after which it drops.