Individual savings accounts come in several guises to suit the spectrum of savers and investors, including simple cash Isas (effectively bank savings accounts that pay interest gross) and stocks and equity-based accounts that shelter managed funds from the taxman.
But for experienced investors who want access to a broader range of Isable investments and have the time and interest to select, monitor and manage their portfolio, the option most likely to fit the bill is a self-select Isa. This is simply an 'empty' tax wrapper, available from many brokers, through which you can buy, hold and sell your own choice of holdings. One such broker is Selftrade whose ISA allows investors to invest in a full range of permitted instruments for a flat £12.50.
Doing it your self brings benefits
The tax benefits are exactly the same as for any other form of Isa: you pay no capital gains tax on any growth in the value of the investments when they are cashed in, and no further income tax on interest or dividends earned, though dividends are subject to a 10 per cent tax credit at source which cannot be reclaimed.
One big plus is the diversity of investments available, although not all brokers offer the full menu. Self select Isa investors can build up their own bespoke portfolio from individual stocks and shares, collective investments such as unit trusts and oeics, investment trusts, exchange traded funds, fixed interest holdings such as bonds and gilts, and cash. However, certain investments are not allowed, including shares listed on the AIM market and funds investing in those shares.
But there are other advantages in running your own portfolio and taking control. Active investors have the flexibility to move in and out of shares, funds or cash as and when they see fit, rather than relying on a manager's judgement. And with online platforms such as the one offered by Selftrade, managing the portfolio has never been easier.
How tax savings add up
Ultimately, however, all Isas are about tax savings, and it's worth looking at what those savings can actually amount to over the long term. Higher rate taxpayers see the biggest tax benefits, so the following examples refer specifically to them. We also assume no changes in rates or circumstances, for simplicity.
Fixed interest holdings such as corporate and government bond funds are a popular choice with income-seeking investors. If you invested the current annual limit of £7,200 in fixed interest investments generating, say, 5 per cent interest, then you’d earn £360 from your investment. Outside the tax wrapper that would be taxed at 40 per cent, reducing your income to £216.
A saving of £144 may not sound like such a big deal; but if you keep saving the full allowance into your Isa for 10 years, you’ll have £72,000 generating around £3,600 of interest, and the tax wrapper will be saving you over £1,400 each year.
The savings are more impressive if you're invested in an equity income portfolio and are reinvesting the dividends, despite the tax credit deducted. Assuming £5,000 a year is invested over 10 years and generates a 5 per cent dividend yield (after 10 per cent tax at source), and leaving capital growth out of the equation altogether, in an Isa wrapper your £50,000 investment will have grown to £66,000 after 10 years.
Outside the Isa, in contrast, dividends earned by higher rate taxpayers are subject to an additional 22.5 per cent tax, so in effect your investment grows at only 3.875 per cent a year, rather than 5 per cent. After 10 years it’s worth £62,000 – that's £4,000 less than if it were 'tax-wrapped'.
What about capital gains? They can certainly mount up: if those £5,000 contributions were invested in growth investments increasing in value at an average 7 per cent a year, then after 10 years the portfolio would be worth £74,000. The Isa therefore provides a safe haven for almost £24,000 of gains, £14,400 of which (after the £9,600 CGT allowance into account) would otherwise be taxable at 18 per cent when they were cashed in.
There is an argument that most investors can keep their capital gains away from the taxman simply by using their annual CGT allowance strategically, but the capital gains protection of an Isa makes for a simple life, as well as providing additional tax efficient capacity for wealthy investors who need both options.
Riding out the storm
Many investors will understandably be reluctant to commit their cash to risky investments in the current gloomy environment. However, the UK stockmarket is a real bargain basement at the moment for shrewd, selective buyers willing to take a suitably long-term view. Those who use their Isa will simply feel greater benefits when, in due course, the market recovers.
It's worth noting, however, that you don't have to plough all your cash into the market in one fell swoop. Stephen Barber, head of research at broker Selftrade, stresses the advantages of drip-feeding your Isa allowance in on a monthly basis. He comments: 'Regular investment can help to manage the risk associated with market timing and take advantage of pound/cost averaging [whereby your contribution buys more units when prices are low and fewer as prices rise, keeping your average purchase price below the average market price].'
Remember, finally, that the alternative – to keep your savings as cash – is becoming increasingly unappealing as interest rates nosedive. Cautious investors might consider a top cash Isa rate of around 4 per cent fixed for a year as a short-term option for up to £3,600 of their Isa allowance, particularly as they can switch cash holdings into an equity Isa at any time; but calling the bottom of any market is very difficult and they may miss the best buying opportunities.
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