If you save or invest, you should have an individual savings account (Isa). More than 20m of us already do, preventing the taxman from taking a £2bn slice of our gains last year alone, but millions more don't. Yet, unlike other tax shelters, Isas are easy, flexible and well worth having. You can open one with a small amount of money, you can take your money out at any time and for every £100 of earnings inside an Isa, you avoid having to hand over as much as £50 of that to the taxman (£45 in the new tax year).
Being able to earn money tax-free (or largely tax-free in the case of dividends) is the main reason behind the enduring appeal of Isas. Around £200bn was locked away in cash Isas and almost the same again (£190bn) in stocks-and-shares Isas as at April 2012, and in the new tax year starting on 6 April you can invest up to £11,520 a year.
You can check the best cash Isa rates on offer in our table in Highest paying cash Isas. Choosing a stocks-and-shares Isa is a rather more difficult process as there isn't one single factor to consider, but we've picked out a selection of shares (10 shares for your Isa), bonds (High five for bonds), investment trusts (10 investment trusts for your Isa) and active (The finest of ISA funds) and passive funds (Trackers for your Isa) that could make good holdings. We've also looked at the process of buying an Isa - see How to buy an Isa - and how to maximise the returns of your existing Isas - Rebalance for the best returns.
But we start by looking at how Isas compare with pensions and how the two products can best be used to your advantage.
FIVE THINGS YOU MAY NOT KNOW ABOUT ISAS
1. Isas are not completely free of tax
If you're investing in equities via Isas, you are entitled to a dividend, which is part of the company's profit (equity Isa funds will pay out an income based on the underlying dividends from a portfolio of companies). All UK dividends are subject to income tax and the tax rate you have to pay on your dividends depends on your own personal tax rate.
However, dividend payments include a tax credit. In fact, you get 90 per cent of your dividends in cash and 10 per cent as a dividend tax credit. The latter is the amount of tax already paid by the company on your behalf as an income tax due on your dividends.
You can't claim the 10 per cent tax credit, even if your taxable income is less than your personal allowance and you don't pay tax. This is because income tax hasn't been deducted from the dividend paid to you - you have simply been given a 10 per cent credit against any income tax due. This rule is not changed by holding your equities in an Isa.
2. Basic-rate taxpayers don't benefit as much
Basic rate taxpayers (20 per cent) don't have an income tax benefit from holding shares in Isas. They pay the same 10 per cent dividend tax rate in or out of an Isa. However, higher-rate taxpayers (40 per cent) don't have to pay any additional tax on their dividends, as they would do if the shares were held outside an Isa. If their investments are held outside an Isa wrapper they'd have to pay 32.5 per cent dividend tax. 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 a yield of 2 per cent. All of this means that basic-rate and higher-rate taxpayers both would benefit more in income tax terms from holding bond funds than equity funds within their Isas. Treat this information with caution, though, as you should never let the tax tail wag the investment dog.
3. The Isa limits are not as set in stone as they appear
You can convert a cash Isa into a stocks-and-shares Isa. But you can't do the reverse.
You can, however, hold cash within a stocks-and-shares Isa as long as it is there with the purpose of buying stocks and shares. But all interest on uninvested cash is subject to a 20 per cent tax charge. If the cash isn't invested in stocks and shares within a certain period then HMRC could require the uninvested funds to be returned to the owner and the interest to be taxed. However, the onus is largely on the provider of the stocks-and-shares Isa to make sure that investors are intending to buy stocks and shares with their cash.
This rule on uninvested cash is one of the anomalies of the system that doesn't quite add up. It has never been made clear why cash left to slosh around in a stocks-and-shares Isa should be such a no-no. After all, it doesn't deprive the government of additional tax revenues. But it does hinder Isas from being run in a way that's consistent with sensible investment practice. As you can't convert a stocks-and-shares Isa into a cash Isa, the alternative is to sell out of your Isa completely - and that would mean you forfeit that portion of your allowance. Once you have taken money out of an Isa, you can't get that part of your allowance back again.
4. You will only benefit fully if you invest every year for the long term
The main tax benefit that stocks-and-shares Isas offer is protection from capital gains tax. But if you make a small one-off investment in an Isa it is unlikely that you will ever save much in the way of CGT, as you already have an annual capital gains allowance (£10,600 for 2012-13) on which you don't have to pay anything. If you had used your full stocks-and-shares allowance every year since Isas were first introduced in 1999, you would have sheltered £112,560* from the taxman. If your investments had grown at 7 per cent a year with the growth reinvested then you would now have £170,089 (source: Hargreaves Lansdown *figure includes extra £3,000 for the over 50s in 2009-10).
There are many examples of investors who subscribed to personal equity plans (Peps) - the predecessor to Isas that then converted to Isas - alongside Isas, who are sitting on portfolios worth £1m or more. Even if the Isa limit was frozen at £11,520 from 6 April 2013, for the next 30 years you have the opportunity to shelter £345,600 from the tax man - plus any growth and income on this investment. Even a 5 per cent gain on £345,600 would be £17,280, busting the capital gains tax allowance (also frozen at the same level) considerably. So if you're going to invest in Isas for the long term, investing the maximum allowance each year, then the CGT benefits can really come into their own.
5. High costs can destroy Isa income tax benefits
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 of his Isa allowance in the popular M&G Corporate Bond Fund. This fund has a distribution yield of 3.39 per cent, which would equate to £169.50 annual income for our investor. So the investor should benefit from a 20 per cent income tax saving of £33.90. But the 1 per cent annual management charge on this fund would be £50 a year, so the investor would actually lose a large part of the sum gained in income tax savings. If you want to keep more of your tax relief, consider investing in a low-cost exchange traded fund, such as the iShares Markit iBoxx £ Corporate Bond (SLXX) which has a total expense ratio of 0.2 per cent.
