When taking out an Isa, you need to think about how it fits into your overall financial strategy. While Isas are excellent tax-efficient savings and investment vehicles, it is not enough to choose one simply for the tax benefits. You need to have clearly defined financial goals. For example, you might have in mind the holiday of a lifetime in a few years or for your retirement in a couple of decades.
Isas at any age
A major attraction of Isas is their versatility. They are just as useful for achieving savings goals in either the short and long term as they are for generating income and growing your capital. This makes them ideal for planning for the future, whatever your age. In your 20s, for example, they can be used to save up for a deposit for a house or flat. In your 30s and 40s, they can be used to save up for school or university fees; in your 50s they can be used to supplement your pension savings; and in retirement you can use them to invest for income.
Cash or shares?
Whether to invest in a cash Isa or a stocks-and-shares Isa also calls for some thought. Cash Isas are most suitable for short-term savings (under five years) because your capital is secure. Stocks-and-shares Isas are suitable for long-term savings (more than five years), but only if you feel you can afford to take risks with your investment.
Everyone needs some savings in a cash account for security and easy access. This emergency cash fund should contain the equivalent to at least three to six months' salary. Cash Isas are an ideal home for this fund – accumulating some of the highest deposit rates, free of the 20 per cent savings tax on interest. Also, many cash Isas are instant-access accounts that make it easy to get your hands on your savings.
Following a rule change, Isas are now even more flexible. You can convert your cash Isa holdings into a stocks-and-shares Isa at any time. This is ideal if you feel able to take on extra risk later in life, for example when you have a higher income, or come into an inheritance. Note, however, that you can't convert an Isa back from stocks and shares into cash if your tolerance for risk goes down, so make sure that you really are comfortable with your decision.
Isas can be an excellent way to boost retirement savings. At retirement, Isas are wonderful as they can be used to generate a tax-free income. What's more, this income will not be counted as part of the investor's ordinary income for age allowance purposes. Age allowance is the extra tax-free personal allowance received by everyone aged over 65 – it is £9,030 for the 2008-09 tax year.
However, if an over-65-year-old's income exceeds a certain limit – £21,800 in the 2008-09 tax year – age allowance is withdrawn at the rate of £1 for every £2 above the income limit. However, you'll never get less than the basic allowance – £6,035 in 2008-09.
ISA vs pension
Whether to invest in an Isa or a pension when investing for retirement is often a grey area. You need to choose the strategy – pension, Isa or a combination of both – that is most appropriate for your situation. Choosing between these different tax wrappers is not straightforward. Both offer tax-free growth with capital gains and tax-free income but, when it comes to making contributions and accessing the proceeds of your investment, the tax treatment is very different.
Pensions have the edge when it comes to making contributions because of their upfront tax relief. Over the long term, this tax relief can make a huge difference – especially if you are a higher-rate taxpayer.
Isas have the upper hand in terms of access – they are tax-free whenever you need to access the capital or income. By contrast, pensions are not accessible until you're 50, or 55 from 2010, and they are taxable when you cash them in. Pensions tend to work best if you are a higher-rate taxpayer when accumulating a retirement pot but then become a basic-rate taxpayer when you come to take an income.
The easy-access advantage of Isas will depend on how disciplined you are with your investments. Even if you designate your Isa as a long-term savings plan, will you really be able to resist the temptation to dip into the proceeds to buy a new car or contribute to a holiday? For this reason, some people like the idea of being able to lock away their money in a pension.
Choosing between the two vehicles may be determined by the amount you can contribute. The maximum annual contribution to an Isa is £7,200, while with pensions you can contribute your entire annual income if you so wish, subject to an annual cap. For the tax year 2008-09, this cap is £235,000.
Independent financial advisers generally recommend that you go for both options. The tax relief on pensions is a huge bonus, especially for higher-rate taxpayers, while Isas offer much more flexibility.
Asset allocation
With both pensions and Isas, the investments that you hold within them can mean the difference between a comfortable retirement and a luxurious one. So you need to invest with a coherent strategy.
First, work out if you are investing for income or growth, or both. Then select appropriate investments to hold within your Isa. This means you’re going to have to learn about 'asset allocation', or constructing a portfolio that is spread across different investment styles, sectors and types of investments.
Academic research has shown that 90 per cent of investment returns can be attributed to the asset allocation mix of a portfolio. Only 10 per cent is down to the success or failure of the professionals who are managing your money.
While there is no perfect formula for investment success, the diversification that is the basic element of asset allocation is simple enough to understand: don't put your eggs in one basket, and you're less likely to lose out.
In theory, you can reduce the risk of your portfolio not growing as desired because each asset type performs differently. Certain assets fare better or worse in different economic conditions. When equities rise, for example, bonds often fall. And when the stock market begins to fall, commercial property might start to demonstrate stronger returns. This behaviour does not always happen, of course, but it generally holds true.
The basic ingredients of an investment portfolio are cash, equities, bonds, commercial property and commodities. If you are investing for the long term, shares should form the bulk of your portfolio as history tells us that, while risky, they have the best potential for growth. Make sure that there is sufficient diversification within your equity portfolio, as many UK investors have too great an emphasis on UK large-company shares. Therefore, it is wise to add some smaller companies and overseas equities for diversification.
It is easy to make some simple asset allocation mistakes that can have huge consequences for your investing career. Research by fund manager Fidelity found that young UK investors are often too cautious and risk-averse in the early phase of accumulating assets. Conversely, the research shows that older investors tend to take on excessive risk very close to their planned retirement dates.
Also, many investors make the mistake of doing detailed asset allocation work at the start of their investment career and then forget about it. But to be successful, your asset allocation has to be reviewed on a regular basis, say once a year, to make sure that your investment portfolio is suitable for your age, risk tolerance and life stage.
Pros and cons ■ Choosing between different tax wrappers is not straightforward. Pensions and Isas allow for tax-free growth with capital gains and income free from tax but, when it comes to making contributions and accessing the proceeds of your investment, the tax treatment is very different. ■ Pensions have the upper hand when making contributions because of their upfront tax relief. Over the long term, this tax relief can make a huge difference especially if you are a higher rate taxpayer. ■ Isas have the upper hand in terms of access – they are tax-free whenever you need to access the capital or income. In contrast, pensions are not accessible until you’re 50, or 55 from 2010, and they are taxable when you cash them in. |
