Handing over cash to the taxman – Her Majesty's Revenue & Customs (HMRC) – is never a pleasant experience. If you're already rich enough, you can cut HMRC out of your life by relocating to the British Virgin Islands, or some other delightful tax haven. But if you're still in the process of accumulating your fortune, there's another acronym you should definitely be familiar with: Isa.
Isa stands for individual savings account and it's one of the most efficient ways of building your wealth. By saving and investing through an Isa, your money grows free of income tax and capital gains tax. What's more, you can have ready access to what's in your account, making it a good place to store funds for a rainy day, a property purchase or even a big contribution to a pension plan later on.
Risk-free or risky: the choice is yours
Whatever you're saving for and whatever your appetite for risk, there's an Isa to suit you. Isas fall into two camps: cash and stocks-and-shares. A cash Isa is essentially a savings account, while a stocks-and-shares Isa allows you to hold riskier investments such as shares, funds and bonds – and even some types of life assurance policy.
Cash Isas and stocks-and-shares Isas are no different in practical terms to a normal bank account or stockbroking account. The only distinction is in their labelling, which gives them tax-exempt status.
How much you can save?
At present, the rules let you put up to £7,200 each tax year into an Isa. That may sound like a modest sum, but it really does add up over time, especially without the taxman dipping into your profits.
Although the annual Isa allowance is £7,200, you can't simply park the whole lot in cash. The yearly limit for a cash Isa is £3,600. If you want to use your entire allowance, therefore, you have to put the rest into a stocks-and-shares Isa. By contrast, if you want to stick the entire £7,200 into a stocks-and-shares Isa, that's absolutely fine.
Be aware that if you've already used up your Isa allowance for a given year and then withdraw some of those funds, you can't subsequently top up your account for that year. So, if you've paid in £7,200 to an Isa, then withdraw £1,000 to spend, you are still deemed to have used your allowance, even though you've now only £6,200 in your Isa.
Move your ISA around
You can have Isas with as many providers as you want, so long as you don't exceed the annual limit. So, you might have £3,600 in a cash Isa at a bank, with another £3,600 in a stocks-and-shares Isa with a fund manager. You can go to different Isa providers every year and there may be a good case for doing so when it comes to cash Isas.
As with ordinary bank accounts, it pays to shop around with cash Isas. This year's juicy interest rate can become tomorrow's below-average rate. For example, you may have several years of cash accumulated in cash Isas with one or more providers, who no longer pay great rates. In response, you can shift your funds to another provider to get a better return. Not all cash Isa providers allow such 'transfers in' from elsewhere, though, so check the terms carefully.
The ISA one-way system
Although Isas are flexible and allow you ready access to your funds, there are some restrictions on how you can move your money about once it’s in an Isa. If you've £3,600 in a cash Isa, you're entitled to switch that into a stocks-and-shares Isa. But if you can't do the opposite of this – ie, switch money from stocks-and-shares into cash.
You may well end up having cash in your stocks-and-shares account that you are waiting to invest in shares or funds when the opportunity arises. While your provider may pay you interest on these funds, you will have to pay 20 per cent tax on that interest, a measure designed to stop people getting around the rules. To learn more about cash Isas, see Moira O’Neill's article 'Cash in on tax-free savings'.
Self-select: perfect for DIY investors
If you take out a stocks-and-shares Isa, you can either pick individual investments yourself or you can rely on a professional manager's expertise.
The do-it-yourself route is known as 'self-select' and is ideal if you are confident in your stock-picking abilities. Managed Isas work well for those who want exposure to a particularly successful manager or fund.
The self-select route allows you to invest in an impressive range of financial assets via a stocks-and-shares Isa. Nevertheless, it isn't a free-for-all. Any security you include must be quoted on a recognised stock exchange, such as the London Stock Exchange, and a variety of overseas bourses. So, you could hold shares traded in Sao Paolo or on Axess – Oslo's junior market – if that's what you want to do. However, you can't invest in Alternative Investment Market (Aim) shares, as Aim isn't a recognised exchange in the taxman's book.
While the rules may permit you to hold all these exotic shares, that isn't to say that every self-select Isa provider will actually enable you to do so. So, if you're hoping to invest in such companies, you should check the fine print of your provider's terms before opening an account.
Exchange-traded funds (ETFs) are another popular holding within a self-select stocks-and-shares Isa. ETFs are listed on a number of exchanges worldwide, with a growing presence here in the UK. As well as tracking entire equity indices, such as the FTSE 100 or the American S&P 500, ETFs provide exposure to government and corporate bonds, foreign exchange and commodities such as gold or oil.
You're equally well served when it comes to managed Isas. While managed Isas can sometimes restrict you to funds belonging to the manager with whom your Isa is held, there are many that let you choose from a broad universe of different funds. These 'fund supermarkets' can also give you big savings on initial charges and other costs.
The cost of ISAs
With cash Isas, there is no cost involved. You earn money just as you would with a normal bank account. However, getting an inferior rate of interest on your deposit is a sort of cost, so it makes sense to shop around for the best rates.
In the case of a self-select stocks-and-shares Isa, you will usually have to pay an annual account fee, followed by dealing charges when you buy and sell shares. As with buying and selling assets outside of an Isa, you need to resist the temptation to overtrade.
Managed Isas typically incur initial charges when buying into a fund. Thereafter, fund managers will typically charge you an annual management fee for their services.
ISAs within your investment universe
You can have Isas alongside other investment products. For example, you might also contribute to a pension plan, such as a self-invested personal pension (Sipp).
One approach is to save money in Isas until you've a worthwhile amount to pay into a Sipp. And when you come to transfer savings from your Isa into your Sipp, you should be able to obtain tax benefits from doing so.
The big difference between pensions and Isas is tax relief. With pensions, you receive tax-relief on what you put in up to a certain limit. So, the government will refund tax paid on what you pay in. Isas offer no such relief.
However, you don't pay anything when you draw money out of an Isa, whereas you typically do on a pension.
MORE ABOUT ISAS...