ISAs explained
Individual Savings Accounts (ISAs) were introduced in April 1999 to replace old-style PEPs and Tessas. At this time of year one begins to think about any unused contributions that you wish to make to your 2011/12 Individual Savings Account (ISA) allowance.
What is an ISA?
An ISA is not an investment in itself, simply a tax-free wrapper into which you can place either cash or shares. An ISA is a tax-efficient means by which investors may save and invest without incurring income or capital gains taxes on the proceeds. An ISA is, it is an investment wrapper.
Whether for cash or shares, an ISA should be the first stop for your savings. The way it works will depend on the type of savings you put in.
Cash ISAs
Use a standard instant access savings account, and basic-rate taxpayers have to give 20% of the interest earned straight to the Government. For higher-rate taxpayers this leaps to 40%, and for 'additional rate' taxpayers it is 50%.
Cash ISAs are simply savings accounts where the interest isn't taxed, meaning it's incredibly rare for a normal savings account to pay more interest. For example, for a cash ISA paying 6% AER to be beaten, a basic-rate taxpayer would need a savings account offering 7.5%, while anyone on the top tax bracket would need a whopping 10%.
Just like normal savings accounts there's a variety of cash ISAs available, such as instant access, fixed rate, and accounts with base rate guarantees. For details of the daily updated best payers, read Top Cash ISAs.
Stocks and Shares ISAs
Share-based investments in various forms are ISA-able. Shares in individual companies may be placed inside what's called a self-select ISA, which are usually managed by stockbrokers.
But stocks and shares ISAs are usually held in collective investment vehicles like unit or investment trusts. These are pooled investments where a fund manager picks a selection of shares based on geographic or sector criteria and the value of the investment depends on the collective performance of the shares picked.
Placing these investments inside an ISA wrapper provides two tax advantages. First, any profits made from share price increases aren't eligible for capital gains tax and second, it enables all the tax on bonds to be reclaimed. For the cheapest way to buy shares ISAs, read the Discount Brokers guide.
There used to be a third category, 'life assurance investment' ISAs, but this has now been merged in with shares.
How much can be invested?
ISAs have become less complex over the years. Each tax year, everyone aged 16 or over for cash ISAs, or 18 for stocks & shares ISAs, has an ISA 'allowance' which sets the maximum that can be saved within the tax-free wrapper from April to April.
The current limit is £11,280, up to £5,640 of which can be in the form of cash. The whole chunk could be used for shares if you wish. There are three basic scenarios:
- Using the maximum cash allowance.You can put £5,640 into a cash ISA, leaving £5,640 available to fill with shares (though you obviously don't have to use this).
- Use it all for shares.You are allowed to invest in £11,280 worth of shares. However this leaves no room for tax-free cash savings.
- Mix n' match.Some amount under £5,640 can be saved in cash, then the rest of your £11,280 allowance put in a shares ISA. For example, someone saving £2,000 in a cash ISA has £9,280 left to invest in shares.
Any savings or investments must be made by 5 April, the end of the tax year. Crucially, unused allowances (or portions of them) don't roll over; they are lost for good. This means an ISA should always be the first place any savings go, as after the tax year ends, any savings or investments stay within the tax-free ISA wrapper for the future, where they'll continue to earn interest.
This means it's possible to have substantial amounts invested within ISA wrappers; £7,000 per year from 1999 to 2008, £7,200 per year until 2010, £10,200 for 2010/11, £10,680 in 2011/12 and £11,280 for 2012/13 then rising by inflation each year after that, plus the gains (interest or investment returns) made in each year.
How can money be withdrawn?
A common mistake is to think an ISA needs to be held for a set length of time in order to reap the tax-free benefits. Luckily, that's wrong! Providing the rules of the individual product allow it (there's loads that do), you can have full, instant access to your money without losing the tax benefits on the rest of your savings in the wrapper.
However, once the money's withdrawn, it can't be returned. A few examples should help clarify this:
Situation: Mr. Rich Devil invests £11,280 in a shares ISA at the beginning of the tax year.
Options: He may sell the whole investment, or part of it, at any time without losing the tax benefits, but no more may be brought inside that year's ISA wrapper.
Situation:Ms. Irma Indecisive invests £2,000 in a cash ISA at the start of the tax year
Options: She may save a further £3,640 in the cash ISA, or £9,280 in a shares ISA (or a mix of the two) before the end of the tax year.
Situation:Irma then decides she needs to withdraw £1,000 of this cash
Options: There's no problem withdrawing the money; for the time the £1,000 was in the ISA the interest it earned wasn't taxed. However the fact she has withdrawn the cash doesn't increase her allowance at all - she can still only put £3,640 more in the cash ISA, or £9,280 in the shares ISA.
Can I switch provider once I'm set up?
There's nothing stopping you switching provider for cash or shares ISAs. In fact, to make sure you continually get a top rate this will be essential, particularly for cash ISAs. Yet it isn't like switching a standard savings account; transferring an ISA is a technical process.
Yet as long as you abide by my golden ISA transfers rule, it should go smoothly:
Never, ever, ever, ever withdraw money from a cash ISA!
You'll immediately lose all the tax benefits.
Instead, speak to the new provider and fill out a transfer form. This will usually include a note you can send to your existing ISA company. Your new company should then sort it all out, including moving the money over for you, keeping your tax benefits intact. If you transfer a shares ISA and it may be necessary to pay another initial charge.
That's the key thing to remember. But when transferring ISAs, what you can do depends on what type of ISA you want to transfer.
- Current year's cash ISA. You may move ALL of this to another cash ISA, or into a shares ISA. You cannot split it into more than one provider or ISA type.
- Current year's shares ISA. You may move ALL of this to another shares ISA, but you can't move it to a cash ISA, or split it between more than one shares ISA.
- Past years' cash ISAs. You may move ALL of this to another cash ISA or into a shares ISA, or SPLIT it between more than one cash or shares ISA.
- Past years' shares ISAs. You may move ALL of this to another shares ISA, or SPLIT it between more than one shares ISA. You may not move any of it into cash ISAs.
Not all ISA providers will accept transfers of previous years' allowances. To see the best ones that will, read the Transferring Cash ISAs guide.
What happened to the Mini and Maxi?
In the past, ISA rules were unnecessarily complicated, making savers fret about whether to go 'Mini' or 'Maxi'. Thankfully since the 2008/09 tax year, this has been consigned to history. Yet anyone who had savings in either of these should be aware of what happened when the terms were dropped.
- Did you have Mini ISAs?These were places to hold cash or shares separately from each other. If you had a Mini Cash ISA, this has now converted into a Cash ISA. If you had a Mini Shares ISA, this is now labelleda stocks and shares ISA.
- Did you have a Maxi ISA?In Maxi ISAs, the two types of investments were bundled together, and bought from the same provider. Now Maxi ISAs have been abandoned, the cash elementwill automatically become a cash ISA and the shares element evolves into a stocks and shares ISA.
- How about my PEPs and TESSAs?
Personal Equity Plans (PEPs) and Tax-Exempt Special Savings Accounts (TESSAs) were forerunners to ISAs during the 1980s and '90s. Once ISAs were introduced, these were phased out, and in April 2008 any money left in them was moved into the ISA regime.
- TESSAs.These were basically cash-based accounts, and between 1999 and 2004 they turned into TESSA-only ISAs (Toisas). These have now all become simple cash ISAs, but possibly at a rubbish rate of interest. However, all the normal ISA rules apply, meaning you can transfer and up the rate (read Transfer to the Best Cash ISAs).
- PEPs.Any PEPs which still exist have automatically transformed into stocks and shares ISAs. You can continue to invest in them within the rules of normal shares ISAs, providing you haven't used another shares ISA during the same tax year. It's also possible to transfer funds from the old PEP into an existing shares ISA.
If you think you had either of these investments, or a standard ISA, but are now not sure what has happened to it, it's possible to track down old accounts and reclaim the funds (plus any interest) inside them. Read the full ‘Reclaim Forgotten Cash’ guide available on the internet.
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