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Everybody has heard the term ISA, particularly around the tax year end, but many people are understandably confused about what they actually are, how they work and how much can be invested. The aim of this article is to hopefully clarify some of the grey areas concerned with ISA’s and help to create a better understanding of what is, in actual fact, a relatively simple savings idea.

Individual Savings Accounts, or ISA’s were introduced in 1999 by the Government to try to encourage those people who did not have any savings to start putting some money to one side for themselves for the future in a tax efficient manner. They were introduced to replace PEP’s (Personal Equity Plans) and TESSA’s (Tax Exempt Special Savings Plan), which had been the previously available tax efficient savings vehicles introduced by the Conservative Government of the time.  

The main benefit of an ISA is that any savings invested within the ISA wrapper will grow free from UK tax (although any distribution units received from a stocks and shares based ISA will be taxed at source at a rate of 20%). Because of these tax benefits, there is a limit to the level of investment, which can placed within an ISA. For the current (2008/2009) tax year the overall limit is £7200 per person, per year, with a maximum of £3600 in cash. This has been increased from the previous limit of £7000 per person, with a maximum of £3000 in cash.

The other main alteration to the rules of ISA’s which has been brought into effect from April 2008 has been the abolition of Maxi and Mini ISA’s. In previous years, an individual could invest up to £7000 into an equity based Maxi ISA, or up to £4000 in stocks and shares within a Mini ISA as well as up to an additional £3000 in a cash ISA. The distinction between Maxi and Mini ISA’s has caused considerable confusion for many individuals over the years, who were unsure of how exactly the rules were applied and how much they could invest in each particular type of investment. From April 2008 this has now been simplified to a straightforward choice between cash ISA’s and stocks and shares based ISA’s. similarly, all the previous tax efficient savings and investment plans, namely PEP’s, will now also be classed as stocks and shares (equity) ISA’s.

As we have mentioned previously, it is now possible to invest a maximum of £7200 in an ISA. This whole amount may be invested in a stocks and shares, or equity ISA, but only £3600 may be invested in a cash ISA. Every one pound invested within a cash ISA reduces the overall allowable limit payable into an equity based ISA by one pound also. For example, if an individual were to invest £2000 into a cash ISA, the maximum amount they could also invest into a stocks and shares ISA within the same tax year would be £5200. However, if a person were to invest £2000 into a stocks and shares ISA, they would still only be able to invest £3600 into a cash based ISA. The cash ISA and stocks and shares ISA for the same tax year may be invested with separate providers, although it is not possible to have two providers for a cash ISA or a stocks and shares ISA within the same tax year.

To qualify to be able to invest into an ISA, an individual must be over the age of eighteen, resident in the UK and eligible to pay UK tax (whether or not they actually pay any tax). The allowances are available each tax year, so therefore it is possible for someone to invest £7200 on 1st April and another £7200 on 6th April (although the overall maximum amount is subject to change each year).

It is also possible to transfer ISA’s from one provider to another. If an individual has ISA’s (or PEP’s) from previous tax years, and they are unhappy with the performance, or risk level of their investment, or maybe they would just like to consolidate their investments within one provider, then it is possible to switch between providers. The application for a transfer should be made to the new provider, who will arrange for the funds to be re-allocated. The funds will remain eligible for tax purposes for the original year that they were invested, which means that the investor will not have used up his or her ISA allowance for the current year. It is important that the transfer is made directly between the new and old provider, if the cash value is withdrawn from an ISA, then the eligibility for that year is lost and the money will be classed as a new investment for the current year. Another change from April 2008 is that it is now also possible to transfer funds from cash ISA’s from previous years directly into a stocks and shares ISA, although it should be remembered that these are two very different types of investment with entirely different risk strategies.

So what is the difference between cash ISA’s and stocks and shares ISA’s? Many people think that an ISA is a specific type of investment in its own right. This is not strictly true. The term ISA is simply a name for a tax wrapper which encompasses an underlying investment. As we have already discussed, this investment may be in cash or stocks and shares.

A cash ISA is very simply a deposit based savings account, usually via a bank or building society. It may be accessible with a pass book (in the same way as a normal savings account would operate) or via the postal system, or Internet. Some cash ISA’s are instant access, but to achieve a more competitive rate of interest, notice may be required before withdrawing funds. As with any other deposit based savings account, interest is added to the original capital invested on a regular basis. The advantage of an ISA over other such savings accounts is that all the interest added is free of tax, regardless of the individual’s personal tax status. As it is invested in cash on a deposit basis, a cash ISA is considered to be a minimal risk investment, however due to the safety element, overall long term returns can be quite low compared with the more adventurous stocks and shares ISA.  

As the name suggests, a stocks and shares, or equity based ISA is an investment made on the stock market and as such carries a higher risk element to it than a cash ISA would, although the level of risk can vary greatly depending on the specific type of investment chosen. Rather than investing directly into stocks and shares within an individual company, an equity based ISA invests in a range of companies, often from different sectors of the stock market, by using a fund which is overseen by a fund manager who is responsible for selecting the individual stocks within the portfolio and managing the same on a daily basis. The type of underlying fund which is commonly used for stocks and shares ISA investments is known as a Unit Trust.

A unit trust is an investment in which the individual investor’s money is “pooled “with that of other investors to buy stocks and shares. It invests in a range of securities, and so spreads the risk for those investing within the fund. The method of investing in a unit trust is by purchasing units, the price of which is calculated by the Manager each day. The price equals the value of the underlying assets within the unit trust at the time of purchase, divided by the number of existing units (this is the equivalent of buying shares directly within a specific company). Each unit trust has a specific aim and the Manager must invest in appropriate investments to meet the aim.

The investor receives units in exchange for the capital invested. The Manager can use this capital to purchase new assets. Over time, the Manager buys and sells securities, aiming to secure for the unit holders within his fund the maximum return in the form of income and/or capital growth. By investing capital in a range of securities through a unit trust, it is possible to participate in a wide spread of investments regardless of the size of your investment.

Although there is no minimum or maximum term to any ISA investment, they should be considered as medium to long term investments, particularly in the case of stocks and shares ISA’s, with a minimum investment term of at least five years, but preferably longer. There are also usually charges involved with investing in a stocks and shares ISA. These could include an initial charge, a bid to offer spread on the purchase and sale of units and an annual management charge.

As can be seen from the above description, a stocks and shares ISA is a far more complicated investment than a cash ISA and there is a vast range of funds to choose from, all of which have different investment strategies, asset classes and risk profiles. Unless you are an experienced investor it is almost impossible to select the appropriate fund for your particular needs and attitude to risk and it is therefore recommended that before investing in such a fund you seek advice from an independent financial adviser who has access to the whole of the market and is able top recommend appropriate funds which are suitable to your individual circumstances. A list of authorised advisers is available from the Financial Services Authority website, www.fsa.gov.uk.