How to keep your savings away from the tax man

Is a maxi better than a mini? Paul Gosling cuts through the jargon of Isas

Isas have proved a popular savings vehicle, with 15 million people signing up for them since their launch five years ago, and holding an average £8,500 each. Their main advantage is obvious: interest and earnings are tax-free. Sadly, some people have probably been put off them by the complex restrictions and confusing names. There are several types of Isa, with different rules on the maximum that is allowed to be saved in them in any one year.

Isas have proved a popular savings vehicle, with 15 million people signing up for them since their launch five years ago, and holding an average £8,500 each. Their main advantage is obvious: interest and earnings are tax-free. Sadly, some people have probably been put off them by the complex restrictions and confusing names. There are several types of Isa, with different rules on the maximum that is allowed to be saved in them in any one year.

For a start, there are mini-Isas and maxi-Isas. Mini-Isas come in three types - cash Isas, equity Isas and life insurance Isas (to be discontinued from the new financial year). Mini-Isas are subject to maximum investments of £3,000 a year for any one class of Isa, subject to a maximum of £7,000 across all classes of Isa. Withdrawals can be made without losing tax relief.

Cash Isas are, in effect, no more than tax-efficient savings accounts, offering interest rates higher than on standard savings accounts. According to the MoneyFacts ratings, the best offers on no-notice cash Isas at present are the Abbey Postal ISA paying 5.35 per cent; Yorkshire Building Society's e-Isapaying 5.2 per cent; and Halifax's IsaSaver Direct paying 5.15 per cent.

Higher rates are available if you are willing to tie your money down longer. Halifax's five-year bond cash Isa pays 5.7 per cent, but requires the full permitted £3,000 to be deposited. And the Lambeth Building Society pays 5.65 per cent, but with a 45-day notice period.

Larger investments are permitted in maxi-Isas, but it is not permitted to open both a mini and a maxi in the same tax year. Up to £7,000 can be invested in any one tax year in a maxi-Isa. The Chancellor had intended to cut this to £5,000 from the 2006/7 tax year, but indicated in last month's Pre-Budget Report that this change will almost certainly be delayed until 2009 - the period for which ISAs have been guaranteed to continue. It also looks as if the £3,000 annual limit for cash Isas will stay in place for the time being, rather than being cut to £1,000 as previously intended.

Typically, maxi-ISAs are invested in shares, investment trusts, unit trusts, OEICs (open ended investment companies) and gilts. Shares and funds Isas can either be held directly in an Isa fund, or else held in a "wrapper" through a broker, enabling the investor to pick their own mix of funds and shares. Even where it is not necessary to use a wrapper, advisers often recommend them to assist moving between funds quickly.

While share values have recovered significantly since the falls of the 1990s, many analysts do not expect stock markets overall to rise much above today's levels. If that prediction proves correct, it is worth considering investing in equity Isas where charges are lower.

It is in this context that the Nationwide Building Society last week launched its Target Return Fund, which requires a minimum investment of just £20, levies only 1.5 per cent annual management charges and no initial charges, and aims to provide a return of Bank of England base rate plus 1 per cent after charges. Should the fund fail to beat the base rate, no annual charges will be made. The fund is managed by Merrill Lynch and investors can make no-notice withdrawals of their money.

But financial advisers cast doubt on the proposition that the priority should be to minimise charges rather than maximise returns. "It's a fragile argument," says Jazz Dayal of adviser Towy Law. "You tend to pay for value." This view is shared by Mark Dampier, head of research at adviser and broker Hargreaves Lansdown. "I never look at costs when buying Isa or equity investments," he says. "It's way down my list of priorities."

Dampier adds that while his preferred investments are mostly unit trusts, if charge minimisation were regarded as important, an investor should consider investment trusts. Investment trusts tend to have lower charges than unit trusts, but provide greater performance volatility.

We asked financial advisers for their recommendations for equity and fund Isa investments. Dampier says he uses his own firm's Vantage Isawrap for his Isa investments, which are led by Caledonian Investment Trust. One of his longer holdings is RIT Capital Partners. In the past, he has invested in Henderson Electric and General Trust, but concedes that it is not doing as well as in the past. One fund he has bought into recently is Artemis Capital, which has had a strong long-term performance.

Daval recommends the Artemis UK Growth fund which has significantly outperformed the market over one, three and five years, though charges are not small at 5 per cent initial and 1.5 per cent annual. "It is my pick for this year as a steady UK stock," says Daval. Another he suggests is the Rensburg UK Select Growth Trust, which has shown a 103.9 per cent rise over the past 39 months, but is a higher-risk fund. His third nomination is the Lazard UK Alpha Fund.

Donna Bradshaw, of IFG Financial Services, suggests Invesco Perpetual Income and Invesco Perpetual High Income funds, which carry initial charges of 3 per cent and annual charges of 1.5 per cent. A higher-risk fund is the Framlington UK Smaller Companies, which carries an initial charge of 5.25 per cent, plus annual charge of 1.5 per cent. For Europe stocks, Ms Bradshaw suggests UK Fidelity European, and in the Far East, Fidelity's China Focus fund. Both carry initial charges of 3.5 per cent, plus annual charges of 1.5 per cent.

Justin Mowbray, of Bestinvest Brokers, says: "Our advice is for individuals to get a good general exposure to these different sectors within their Isa equity portfolios. If their portfolio currently comprises UK Growth funds, the investor should consider investing in some of the other sectors above to achieve a better balance."

His suggestions are in the UK growth sector, Framlington UK Select Opportunities and JPMF UK Dynamic. Among UK equity income funds, he nominates Jupiter Income and Artemis Income. For UK smaller companies, Mowbray suggests Framlington UK Smaller Companies. For European stocks, the recommendation is for Artemis European, Threadneedle European Select Growth and Cazenove European. In North America, he goes for Legg Mason US Equity, Legal & General US Index; in the Far East, the Aberdeen Far East Emerging Economies fund; and in Japan, the DWS Japan Growth.

'I want to minimise my fund charges'

Gordon Kempsell is a keen user of Isas, using up his maximum £7,000 limit each year and having transferred his old PEPs into Isas. "It's mainly for tax relief," he says. At 51, Kempsell is saving for his retirement, but placing more in his pension fund is not an option as he uses up his permitted allowance. So he also regularly invests to his Isa maximum.

A self-employed cameraman, Kempsell has decided to change strategy. Previously, his objective was to achieve good returns while minimising charges, so he invested in UK stock-market tracker funds, which charge less than 1 per cent per annum. But the value of these holdings fell badly in recent years, along with the stock-market fall.

Taking advice from Bestinvest, Kempsell has decided to seek higher returns, along with a more diversified portfolio, with less emphasis on UK major-company stocks.

Now he will place £4,500 in the Jupiter Merlin Worldwide Portfolio, and £2,500 in the New Star High Yield Bond. Charges are mitigated by placing the order through a large broker. Jupiter's charges would be 5.25 per cent initially, and 1.5 per cent annually, but the initial charge is reduced to 0.25 per cent through Bestinvest. And New Star's initial charge is 4.25 per cent, with 1 per cent annual charge, reduced to 0.5 per cent through Bestinvest.

New Star provides a fixed income of 5.1 per cent, while Jupiter offers Kempsell exposure to US, European and Far East equities. Bestinvest's advice was free, and part of its commission used to reduce initial fees.