Why opening an ISA account has never been more important

Whether it's cash or stocks and shares, it's time to sort out your tax-free savings before the window closes.
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The Independent Online

The countdown has begun again. In just over a month's time – on 5 April – it will be the end of the current tax year, which also means the last day on which you can put your annual Individual Savings Account allowance to work.

Independent financial advisers and economists rarely agree, but one issue on which they are united is that anyone with money to save should make the most of this opportunity to tax-efficiently invest up to £10,200.

The argument in favour of using ISAs is particularly compelling given the perilous state of the nation's finances, according to Mark Dampier, the head of research at Hargreaves Lansdown – even though ISA allowances are now index-linked.

"At some stage in the next few years, the Government is going to see how much money is being put away in a tax-free environment on top of pensions," he warns. "I can see them maybe doing something such as reducing the allowances."

The fact that inflation recently hit 4 per cent also emphasises the importance of making sure your money is working within – and benefiting from – a tax-free environment, says Julie Smith, savings analyst at the Fair Investment Company

"An ISA should always be your first option, because the tax-free element means you can earn more than an equivalent savings account," she says. "It may also be worth consolidating all your old ISAs into one new one with a better rate." So, how do ISAs work and what do prospective investors need to know?

What are the ISA basics?

Individual Savings Accounts (ISAs) are tax-efficient savings vehicles that were introduced by the Labour Government in 1999 to encourage more people to start putting some money away.

There are basically two different types of ISA: cash ISAs for anyone aged at least 16, and stocks and shares ISAs for anyone aged 18 and over. Which one you go for will depend on your appetite for risk.

The amounts that can be invested each tax year in an ISA have steadily increased over the past decade. You can presently put away £10,200 a year, but this will rise to £10,680 from 6 April 2011. It means couples can tax-efficiently invest more than £20,000 a year, which will be more than enough for most people's needs.

The principal benefit of an ISA is that any gains made aren't liable for either income or capital gains tax. This makes them a very attractive way to invest for millions of people and has been for many years.

You can save in two separate ISAs in any one tax year – one cash ISA and one stocks and shares ISA. However, you can't save in more than one cash ISA or more than one stocks and shares ISA in the same tax year.

According to Justin Modray, founder of website Candid Money, these tax savings are particularly beneficial over the longer term, even if they don't seem all that exciting or worthwhile over the short term.

"A higher-rate taxpayer investing £5,100 into a stocks and shares ISA might save around £1,500 in tax over 20 years, rising to £2,000 when using a cash ISA," he explains. "ISA income can be useful during retirement as it doesn't count towards the limit for the increased age-related personal income tax allowance."

Given the tax benefits, it won't be a surprise to learn that ISAs have been popular. At the last count, the total value of assets held in such tax efficient products was around £350bn. In the year to 5 April 2010, almost 15 million accounts were opened – 11.9 million cash ISAs and just over 3 million stocks and shares ISAs.

So let's now take a closer look at the two types of ISA.

Cash ISAs

Cash ISAs are tax-free savings accounts that should pay you interest. They are offered by a huge number of high-street institutions and can be opened up in branches, online or over the phone. You are allowed to put up to half the annual allowance in a cash ISA. This means up to £5,100 in the current tax year and £5,340 in 2011/12.

"These should be the bedrock of anyone's savings," says Geoff Penrice, an independent financial adviser with Honister Partners. "Before even considering putting money into other accounts the full allowable allocation should be tucked away in a cash ISA, preferably one that is paying a good rate."

Don't just pick a cash ISA and stick with it. You must monitor how the rate you are getting compares with other products on the market – and consider moving for better deals.

Stocks and shares ISAs

You are allowed to put your entire annual allowance into a stocks and shares ISA – up to £10,200 in the current tax year and up to £10,680 from 2011/12. However, there is an important point regarding the tax treatment of these products.

While we have already established that any income generated by a cash ISA is completely tax free, the situation is not the same for stocks and shares ISAs with investments that receive dividend income.

In these instances a tax credit of 10 per cent will have already been taken before it is paid to you that can't be reclaimed. An exception is fixed-interest investments where the income is derived from interest and is treated the same as a cash ISA.

Stocks and shares ISAs have the potential to deliver better returns than cash ISAs – although investors need to appreciate they should come with health warnings. As they invest in assets such as shares and corporate bonds, they are exposed to stock market fluctuations, which means the value of a person's holding can rise and fall over time.

Choosing what's right for you?

We have outlined the options so how should investors decide where to put their money? Well it all depends on their attitude to risk and whether they are saving for something specific in the future for which they will need a certain amount.

The best definition of risk is gauging the impact on your life of losing everything that you have invested. If, therefore, the money you are saving is crucial to your future then a sizeable chunk – at the very least – should be held in a cash ISA.

If, however, you don't need the money immediately and are happy for the value of your holdings to fluctuate over the course of the next couple of decades then a stocks and shares ISA may well be the best option.

Dealing with providers

Do your research with providers and check their terms. Some ISA managers, for example, give you cooling off or cancellation periods in which you can change your mind about buying.

In these instances – and if you do change your mind and cancel the ISA within the agreed period – any payments made will not count as a subscription into an ISA in that tax year and you will be free to put money into an alternative ISA.

Of course there will be times when things go wrong. If this proves to be the case then the first step towards resolving it will be to take it up with your ISA manager, which will have a complaints procedure in place.

If, however, you are unhappy with the outcome you can go to the Financial Ombudsman Service. This independent service is free to use and aims to resolve individual disputes between consumers and financial firms.

General rules of ISAs – and what to do next

Regardless of whether you opt for a cash ISA, a stocks and shares ISA, or one of each, a number of rules that will apply.

Firstly, money held in a cash ISA can be transferred into either another cash ISA or a stocks and shares ISA – but not the other way around.

Secondly, any money you want to move must be transferred directly between the old and new managers. You cannot facilitate this yourself by closing one account down, withdrawing the money, and then investing it elsewhere. If you do this then it would be treated as a fresh investment and be subject to the annual limits.

Thirdly, you can transfer all of the money invested in an ISA during the past – or only some of it if you prefer – but if you want to transfer the money you have put into an ISA in the current tax year, then you must transfer all of it.

The next steps

Although you have until Tuesday 5 April you must not leave it to the last minute. The deadlines by which you need to submit applications or action transfers will vary according to the provider, but it is best to give yourself at least a week – which means your business needs to be sorted by the week beginning 28 March.

In addition, it's also worth sparing a thought about next year as well. Don't forget, investment decisions should be made as early as possible in a given tax year so that your money has the maximum amount of time in which to work on your behalf.

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