ISA: Shelter your savings before it’s too late

If you’ve not organised your ISA this year, do it now or you’ll pay more tax than you should, says Simon Read

You only have a week left to use your individual savings account (ISA) allowance for the current tax year. ISAs are a great way to build up a decent nest egg without paying any income tax on the proceeds or capital gains tax on the growth. But if you don't act by 5 April, you'll lose the chance to shelter up to £10,200 of savings from the grasp of the tax authorities.

"Investors need to act fast if they want to use this year's ISA allowance. Time is running out for many postal applications with deadlines falling before the 5 April," warns Annabel Brodie-Smith, communications director of the Association of Investment Companies. "However, for those short of time, there are some later online ISA deadlines."

Analysis of sales from last year's ISA season shows that the investment management company Fidelity International received 27 per cent of its ISA applications in the final week of the tax year, with 10 per cent people leaving it to the last few days, applying between 2 April to midnight on 5 April.

Half of your annual ISA allowance – £5,100 in the current tax year – can be stashed in a cash ISA, or you can put the whole lot into an equity ISA, which invests in stocks and shares or investment funds. "Whichever way you prefer to invest, don't leave buying your ISA to the very last minute. Use this weekend to get your 2010/11 application done and dusted ahead of next week's deadline and beat the rush," advises Rob Fisher, head of UK personal investments at Fidelity.

Deciding which type of ISA to choose depends on how comfortable you are with stock market investments. Over the long term, shares tend to offer better returns than savings accounts, but they do go up and down. Seeing the size of your savings shrink can be uncomfortable. If you feel that you couldn't cope with that, then you may want to use your maximum cash ISA allowance, and then find low-risk funds for the rest of your ISA allowance.

On the other hand, if you're fed up with the paltry returns you've been getting on savings accounts, including cash ISAs, then you may feel ready to take a punt in return for the potentially higher returns you could achieve.

"Choosing between a cash and investment ISA is really down to how you balance risk and reward," says Carl Howard, head of direct investments at Barclays Bank. "Investments wrapped in an ISA offer greater potential rewards. However, like any investment, these returns aren't guaranteed. Cash ISAs give a fixed return and so are better suited to the more risk averse. You will also need to consider how long you are prepared to lock your money away for. Investing is not typically about quick wins, and we would look at a five-year horizon for keeping an investment ISA. Cash ISAs are more suited to short-term savings needs and can provide instant access to your money."

In other words, cash ISAs are the perfect place to keep an emergency fund that you can draw on when you need it, such as to pay for unexpected repairs to your home or car.

"But your overall goals should play a big part in determining what type of ISA you go for," advises Howard. "Are you saving for a rainy day, or do you have a specific target, like retirement, a new house or holiday in mind? And if you do, can you get the returns you need through a cash ISA – or is it worth considering the greater potential returns from a varied portfolio of investments?"

Anyone who already has a cash ISA could consider switching it to an equity ISA, although you are not allowed to switch it back. Even if you don't want to switch it to an equity ISA, you should check the rate you're getting, says David Black, banking analyst at Defaqto. "It is worth reviewing your existing cash ISAs to see if you can get a better deal elsewhere. Some may be paying as little as 0.01 per cent," he warns.

He also says investors should be wary of the current crop of fixed-rate ISAs being offered by banks and building societies. "At the moment fixed-rate cash ISAs generally are paying higher rates than variable interest rate cash ISAs, but bear in mind that a rate that looks attractive now may not do so in two or three years time if the base rate has increased dramatically during the intervening period."

Another warning with cash ISAs is that many are now offering attractive-looking rates, but include an introductory bonus. When that bonus rate ends – usually after a year – then the rate could prove to be much less attractive. "If you are on the ball and manage to switch your ISA as soon as the bonus expires then it's no problem. however if you delay your decision, the accounts with the big bonus rates will suddenly turn sour and offer you a much poorer return on your cash," warns Andrew Hagger, analyst at Moneynet.co.uk. "When you open your ISA, or any other savings account for that matter, make a note in your diary or your iPhone or iPad a couple of weeks before your rate is due to plummet so you're in a position to move your cash before the interest return drops to a derisory level."

Sylvia Waycot, spokesperson for Moneyfacts.co.uk, agrees: "Interest paid in the second or subsequent year of an ISA that had an introductory bonus can be a very sad imitation of the original attention-grabbing rate because, without the bonus element to prop it up, the remaining rate paid can be very low."

Waycot says pitfalls to watch out for are long-standing account names, because they will be issue-based and each issue will pay a different rate. The older the account generally means the worse the rate. "To add further confusion, some accounts are not issue-led but date-led, so you can have three people opening accounts with the same name in different weeks all getting different rates regardless of the account, to all intents and purposes, being the same."

But with interest rates stuck at record a low for the past two years, the temptation to devote your entire ISA allowance to equities is strong, says Rob Burgeman of independent private client investment managers Brewin Dolphin. "With the backdrop of rising inflation and interest rates at their current 0.5 per cent, this leaves savings stuck in the invidious position of interest rates substantially below prevailing levels of inflation," he says. "In other words, they are being charged to hold cash.

"However, this stagflationary environment – I prefer the phrase slugflation (sluggish growth and inflation) – is not necessarily bad for all asset classes, at least over the medium term. Conventional government and corporate bonds tend to perform badly as they offer no ability to preserve capital in real, inflation-adjusted terms.

"However, companies who own real assets and make or sell real products, generating real profits tend to see these 'real' numbers preserve their value over time. Equities would seem to offer the safest haven over the medium term, provided one is happy with the volatility along the way," says Burgeman.

If you are taking a longer-term outlook with your savings, then finding the right stock market-linked investment could be the answer. If you're saving towards a new house, you may be thinking about a five-year period, for instance. On the other hand, saving towards retirement could mean building up your ISA investments over a 30 year period.

The length of time you have should govern how much risk you are prepared to take. The simple rule with investments is this: the great the risk, the greater the potential reward. If you are investing for 30 years you could afford to take greater risks in the early years knowing that you have plenty of time to recover and put things right if things go wrong.

However, if you are only planning to invest your money for five years or less, you will probably want to avoid the riskier investments as, if things do go wrong, your savings won't have time to recover from any losses.

What type of investments should you choose? Again, that depends on your attitude towards risk. If you are a keen investor and have an idea about the different types of shares and funds that you would like to use, then you could go for a self-select equity ISA.

"More and more investors are realising that self-select ISAs offer real flexibility in the hunt for better returns," points out Rebecca O'Keeffe, head of investment at online stockbroker Interactive Investor. "Depending on the level of risk investors are willing to take, they can invest in a mix of funds, shares, cash, or bonds. You can also trade exchange-traded funds (ETFs) within a self-select ISA, which are becoming increasingly popular among private investors who are looking for low-cost investment options."

According to the company's research, the number of people who are only taking out a self-select ISA has gone up by more than 50 per cent so far this tax year, so that 31 per cent of all investors are choosing them, with a further 44 per cent investing in funds ISAs or a mix of cash and equity ISAs.

A financial adviser can talk you through investment options or you can research it yourself at one of the online funds supermarkets. With any investments, there will be dealing charges for buying and selling the share or fund, and there will be annual management charges to bear in mind, which eat into your returns.

Look for special deals from fund managers and ISA providers that have dropped the initial charge or cut annual management fees, and the savings can make a real difference. If you are happy with a tracker fund – which invests in a selection of shares of a particular index, such as the FTSE – then you can expect the charges to be lower. However, with these passive funds, as trackers are known, the potential returns could be lower. Active funds, where there are managers who make regular investment decisions to buy into or sell shareholdings, can offer better returns. However, there are obviously no guarantees when it comes to the stock market and a tracker fund is a way to reduce the risk, albeit by accepting potentially average returns.