ISA explained

If you’re thinking about investing your hard-earned cash an ISA could be a good place to start.
An ISA, or individual savings account, is essentially a wrapper which shelters your savings and investments from income tax. This means your money can grow more quickly than if you held your investments outside an ISA.

Types of ISA

There are two types of ISA available: a cash ISA, which is a tax-free savings account, and a stocks and shares ISA. A stocks and shares ISA lets you put your money in a wide range of investments, including individual company shares, bonds, investment trusts, investment funds, exchange -traded funds and trackers. Because they are held in an ISA, any gains you make on your investments are tax-efficient.

A stocks and shares ISA is riskier than a cash ISA because stock market investments can fall in value as well as rise, but it has the potential for a higher return particularly in the current environment of low interest rates.

Stock market investments have outperformed cash in 90% of the 10-year periods since 1899, although you must remember that past performance is not a guide to future performance. The general consensus is you should put your money away for a minimum of five years to smooth out any ups and downs in the market.

ISA allowance

The government sets the maximum amount that you can invest in ISAs each year. For the 2015/2016 tax year the ISA allowance is £15,240. You can invest the full amount in a stocks and shares ISA, the full amount in a cash ISA or split your allowance between the two. Your allowance is based on what you save, not growth or interest earned.

To pay into a stocks and shares ISA you need to be at least 18 and resident in the UK.

Funding your ISA

You can fund your ISA via a lump sum or set up a direct debit to make regular payments. Regular investing enables you to take advantage of pound cost averaging – essentially balancing out price highs and lows over a period of time. You invest the same amount of money each month and when the price is high you get fewer units for your money and when it is low you get more units for your money. This reduces the risk of getting the timing wrong.

Once you have opened your stocks and shares ISA you then need to decide what sort of investments you want to put into it.

Tax benefits

A stocks and shares ISA has several tax benefits which vary depending on whether you are a basic-rate, higher-rate or additional-rate taxpayer.

Interest in a stocks and shares ISA is paid tax-free, which means a saving of 20% for basic-rate taxpayers, 40% for higher-rate taxpayers and 45% for additional-rate taxpayers.

If you sold or cashed in investments held outside an ISA you would have to pay capital gains tax if you exceeded the £11,100 allowance. All capital gains held in a stocks and shares ISA are tax-free.

Dividends are paid with 10% deducted at source and there is no further tax to pay regardless of whether you are a basic-rate, higher-rate or additional-rate taxpayer. If you received dividend income outside an ISA basic-rate taxpayers would still pay 10% but high-rate taxpayers would pay 32.5% and additional-rate taxpayers would pay 37.5%.

Withdrawals and transfers

You can withdraw your money from your ISA when you need it, but if you do take money out you won’t be able to pay it back in if you have reached your annual allowance limit. You will also lose the tax benefits on the withdrawn money.

You don’t have to keep your money in your ISA with the same provider. If you want to move from a cash ISA to a stocks and shares ISA you can transfer previous years’ cash ISAs without it affecting your current year’s allowance. You can transfer your current year’s cash ISA into a stocks and shares ISA but the rules state that you must transfer the whole amount.

The same rules apply to stocks and shares ISAs but providers might charge exit fees to transfer your holdings. There are two ways of transferring your holdings: by cash or in-specie.

Cash transfers

If you opt for a cash transfer all your holdings will be liquidated and the proceeds paid to the new provider. A cash transfer is usually free and is relatively quick but you will be out of the market until the transfer is complete.

In-specie transfers

In an in-specie transfer your holdings move across as they are. Your money remains in the market throughout the transfer process and there won’t be any capital gains tax liabilities. In-specie transfers are more expensive and they won’t be possible if the new provider doesn’t offer the exact same fund version as currently held.

Junior ISAs

If you want to save for your children through an ISA you could choose a Junior ISA. Like the adult version a Junior ISA lets you make tax-efficient investments, but they are carried out on behalf of a child.

You can currently save up to £4,080 a year into a Junior ISA. You can put all the money in a cash Junior ISA or all of it in a stocks and shares Junior ISA or any mix of the two. A stocks and shares Junior ISA allows the same wide range of investments as an adult ISA does.

Your child cannot touch the money until they turn 18, but they can take control of it at age 16. If your child is 16 or 17 they get two ISA allowances – the Junior ISA allowance and the adult cash ISA allowance of £15,240. They are not able to open a stocks and shares ISA until aged 18.

Following a rule change on 6 April 2015 people with a Child Trust Fund can now transfer to a Junior ISA. By transferring your child may have a greater choice of investments and they could achieve better returns and pay lower charges.