Simple, flexible, tax-free: a beginner's guide to ISAs

What is an ISA?

What is an ISA?

An individual savings account (ISA) works in a similar way to a regular bank or building society savings account - except that any returns you make are tax-free.

ISAs were introduced by the Government in April 1999 to replace personal equity plans (Peps) and tax-exempt special savings accounts (Tessas). They are designed to be more flexible than Peps and Tessas in order to encourage a greater number of people to save for their future. They avoid the drawbacks of both Peps - which were seen as being skewed in favour of those with a relatively large amount of money to invest - and Tessas, which imposed penalties on investors accessing their money in less than five years.

Who can buy an ISA?

Anyone who is over 18 years old and resident in the UK. From April this year, 16- and 17-year-olds can get in on the act, too, although the amount they can invest is limited to £3,000 in a mini cash ISA.

How much cash do I need?

Everyone over the age of 18 gets an annual ISA allowance of £7,000 each tax year. So this year's allowance needs to be invested before the end of the tax year - 5 April.

Theoretically you can start an ISA with £1, but most providers require a minimum investment of £500. You can pay into your ISA at regular intervals, drip-feeding your payments to avoid the risk of investing one lump sum when the stock market is at its highest. However, some people invest a lump sum - even as much as their £7,000 allowance.

Is it true that there are two types of ISA?

Yes, there's the mini and the maxi ISA. You can invest in one or the other in any one tax year, but you can't have both. If you do take out a mini and a maxi in the same tax year, you could be liable for a fine from the Inland Revenue.

So what's the difference?

Mini ISAs come in three forms - cash, insurance or stocks and shares. You can invest up to £3,000 in a mini cash ISA, a further £3,000 in stocks and shares and £1,000 in a mini insurance ISA. You can hold one, two or all three of these types of mini ISA in one tax year. They do not all have to be purchased from the same investment house.

What's the advantage of a mini cash ISA?

These ISAs have proved the most popular with the general public because they are the simplest to understand. They are also low risk because no money is invested on the stock market. Instead they operate more like a bank or building society account, the difference being that the returns are tax-free. In addition, your funds are easily available - not locked away for five years, as was the case with a Tessa. Your cash is available for withdrawal whenever you wish, although remember that if you have already invested your full £7,000 in mini ISAs, it cannot be replaced in the same tax year.

Why choose a maxi ISA?

The big advantage of a maxi is that you can invest up to £7,000 in stocks and shares. The stock market offers greater potential for higher returns than investing with a bank or building society, although of course, there is also a chance of bigger losses.

You don't have to invest the full allowance in equities, however. You can also include cash and insurance if you prefer, up to a limit of £3,000 for cash and £1,000 for insurance, investing the remaining £3,000 in equities.

You are allowed only one maxi ISA in any one tax year, and if you choose to split your investment into cash, insurance and stocks and shares, these components must be invested with the same fund manager, making the maxi ISA less flexible than the mini.

Can I carry any part of my allowance over to next year?

No. Your allowance for this tax year will be lost for ever on 5 April. After that, you are limited to next year's allowance (also £7,000).

Which ISA should I choose?

Many equity ISAs are UK-based so your money is invested on the London Stock Exchange. As the UK market is likely to be familiar to you already, it's a good place to start.

In the longer term, a more balanced portfolio will require investments in European and international funds.

Themed funds, such as those focusing on technology or health care, have attracted interest among investors. Bear in mind, however, that these tend to be much riskier than general funds, owing to the narrower investment range.

OK, I'll start an ISA before the end of this financial year. How do I go about finding the one that best suits my needs?

You really are spoilt for choice. If you aren't sure what you need, it might be worth consulting an independent financial adviser. Alternatively, if you're feeling more confident, you could do your own research using the national press and the internet. All investment houses have their own websites giving further information.

When you've made your choice and want to buy an ISA, it may be worth going through a discount broker to save on the initial charge (see page 10).