Beware tax-free lemons

As the deadline for using up this year's individual savings account (ISA) allowance draws nearer, the temptation to rush into one without really thinking it through can be hard to resist. But though the aim of an ISA is to save you tax, and saving tax is a good idea in anyone's book, it is important to avoid some common pitfalls.

As the deadline for using up this year's individual savings account (ISA) allowance draws nearer, the temptation to rush into one without really thinking it through can be hard to resist. But though the aim of an ISA is to save you tax, and saving tax is a good idea in anyone's book, it is important to avoid some common pitfalls.

Remember our words from last week: "Don't let the tax tail wag the investment dog." Making a good investment and paying tax on the profits is usually a better idea than making a poor investment but saving tax on it, so don't rush into buying a tax-free lemon.

Be careful of share-based ISAs that offer specific rates of return. Anything that comes with a headline like "Whizzo Index Tracker: 7 per cent return" should be treated with caution. If you check the small print, you'll find that it's a rate of return based on some past period they're quoting, and as such it tells you nothing about your future rate of return. The stock market performed very well in the Nineties, but since early 2000 things have been a bit less rosy. If you invest in a stocks and shares ISA, what you're going to get is the future return achieved by those shares less charges. And nobody can tell you how many per cent that's going to be.

That brings us on to a more general principle. Remember the old saying that "past performance is not necessarily a guide to future performance"? You'll find it, or some similar words, tucked away in the small print of most adverts for investment products. But some of those same advertisers then publish league tables and proudly proclaim how their products have beaten those of their rivals over some historical period. That past performance warning is true, and several studies have found no statistical correlation between the best-performing investment funds in any one five-year period and the best performers in the subsequent period. And how often are periods of steep gains followed by big falls? More often than we'd like, as any investors in technology know to their cost.

And when it comes to comparing returns after all charges, most actively managed funds regularly fail to match the stock market average when examined over the long term. There have been some very good fund managers over the years, but they are rare and can be tricky to identify. In fact, most managers fail to match simple index trackers in making long- term profits for customers.

Once you've understood the way investment products are often advertised, and how the simplest products (like trackers) can often be the best products for many investors, think more about those charges.

All ISAs carry an annual charge, and the variation between different funds can be surprising. Some can be as high as 2 per cent, with the lowest coming in at 0.5 per cent or less. That can make a big difference to your returns in the long run. And make sure you include all of the charges when deciding on the best home for your money. It can be hard work uncovering them sometimes, but they have to be disclosed in the paperwork accompanying any application.

As ISAs are all about tax, consider your personal allowances. Are you ever likely to use up your capital gains tax allowance in any one year? If not, sheltering shares in an ISA may only save you some income tax on dividends you receive, and that could easily be swallowed up by those charges.

If you are able to use at least some of your annual capital gains allowance and can come close to using your full ISA allowance every year, then you can probably make worthwhile savings by going for a shares ISA. But if you just plan to invest a couple of thousand pounds per year in shares, the benefits are more dubious.

The bottom line, then, is that you need to understand what you're buying (like most things in life, really), and you need to understand exactly what you will be saving, and how much you will be paying for the privilege, before signing on the dotted line.