Individual savings accounts (Isas) remain the most popular investment product for the fourth year in a row, according to research by stockbroker TD Waterhouse. Through using your annual stocks and shares Isa limit (currently £10,200), the argument goes, you can accumulate a large tax-free nest egg over several years. But all may not be as straightforward as it seems. Here are three things you need to know about Isas before you invest.
1) High costs can destroy the income tax benefits of Isas
The average fee charged for a stocks and shares Isa is often more than the tax savings. For example, a basic-rate taxpayer invests £5,000 in a UK corporate bond fund Isa. Assuming an average yield of 4.5 per cent (£225), this investor should benefit from a 20 per cent income tax saving of £45. But as the average 1 per cent charge on such a fund amounts to over £50 a year, the investor would actually lose more in charges than they've gained in income tax savings. If you want to keep more of your tax relief, consider investing your £5,000 instead in a low-cost tracker fund or exchange-traded fund, such as the iShares Markit iBoxx £ Corporate Bond (SLXX) which has a total expense ratio (TER) of 0.2 per cent (£10).
Higher rate taxpayers also benefit from a low-cost approach. Although basic rate taxpayers don't have an income tax benefit from holding shares in Isas, higher rate taxpayers don't have to pay any additional tax on their dividends, as they would do if the shares were held outside of an Isa. For example, £10,000 invested in an equity growth Isa would achieve an income tax saving for a higher rate taxpayer of around £50 per year - assuming an average yield of 2 per cent.
However, the cost of an actively-managed equity growth fund is typically £150 a year. So the investor stands to lose three times what they've gained in tax relief. In contrast, investing in equities via a tracker fund can cost less than 0.3 per cent a year, or £30 on a £10,000 investment. You can read about the cheapest tracker funds .
2) Top-performing funds aren't the answer
Most efforts of fund investors go into identifying funds that they think will deliver good performance. However, it is well documented that top-performing funds change over time and only a small proportion beat the index on a consistent basis. Giant index fund manager Vanguard has a vested interest in putting the case for index investing but its research shows that only 22 per cent of the top-ranked funds over an initial five-year period remained in the top rank over the subsequent five-year period.
At Investors Chronicle we try to help you to find top-performing funds but we also think that keeping costs low should be a top priority. How much you pay for a fund is one of the few elements you can control in investing. However, according to Vanguard's research, only 9 per cent of investors looked at the cost of the fund and went with the lowest costs.
3) You will only benefit fully if you invest every year for the long term
The main tax benefit that share Isas offer is protection from capital gains tax (CGT). But if you make a small one-off investment in an Isa then it is unlikely that you will ever save much in the way of CGT, as you already have an annual capital gains allowance (£10,100 for 2010/11) on which you don't have to pay anything.
If you had invested your full allowance into a stocks and shares Isa each year since 1999, you would have invested a total of £87,600. Assuming growth of 7 per cent a year, this would now be worth £137,882. If 7 per cent growth continues on that pot it is now notching up an annual gain of £9,651, certainly nearing the CGT limit. Some investors have managed to turn their Isas into much bigger sums - for example . A half share of a 7 per cent annual gain on this portfolio would be £42,000.
So if you are going to be a long-term investor in Isas, investing the maximum allowance each year, then the CGT benefits of Isas can really come into their own.