It’s that time of year again when savers and investors rush to top up their ISAs to the maximum allowed in the current tax year, ready to start again on the next one come April 6. If you want to take advantage of your full allowance for the 2010/2011 tax year--£10,200 either entirely in bonds and shares or up to half in cash--now is the time to do it.
What?
There are many common misconceptions about ISAs, so let’s start at the beginning. An ISA is an individual savings account. These were set up by the government in 1999, in order to promote more of a savings culture here in the UK. You can hold cash in an ISA or you can hold stocks and shares, but the key thing to remember is that it’s just a tax efficient wrapper, you still need to make choices about what you put in that wrapper.
The term ‘tax-efficient wrapper’ means you can save cash or invest in shares and bonds and enjoy the benefit of paying neither income tax on interest or dividends nor capital gains on portfolio returns. Note, however, that any UK dividend income received within a stocks and shares ISA will be subject to a 10% non-refundable tax credit.
A cash ISA will offer you a set interest rate, so you know that, for example, if you put £1,000 in a cash ISA offering 3% interest at the beginning of the financial year, this will have increased to £1,030 come the next tax year. ISAs in the past have offered more appealing interest rates but given the Bank of England’s current historic low rate of 0.5% you could be hard pushed to find many cash ISAs offering much more than 3% APR—do be sure to shop around for the best deal. Unfortunately this is not a great incentive to save given that current inflation means your savings could be losing value in real terms in spite of the interest gained. Investing is a different story, however.
Why?
Why would I want to use an ISA? If you’re saving for a specific near-term goal, such as a new car or deposit to buy a house, the cash portion of your ISA can help you do so. For longer-term goals, such as saving for retirement, you may want to make the most of these tax-free wrappers to invest in stocks and bonds. The longer your time horizon the more risk you can afford to take, which is why someone in their thirties planning to retire at 68 might want to create an investment portfolio that is heavily-weighted towards equities. You can only hold one ISA per year, but you could feasibly create a portfolio constructed of multiple ISAs over multiple years with decreasing degrees of risk as you near your investment goal.
The UK government is increasingly putting the onus on the individual to ensure they have adequate resources to cover their retirement years. £1,000,000 is hard to come by if you need it at short notice but start saving and investing early and all those pennies could quickly add up to substantial pounds, especially with the magic maths of compounding.
How?
The maximum that you can put in an ISA wrapper this tax year is £10,200. You can choose to use that in a variety of ways: You can have a cash ISA, which can go hold up to £5,100; or you could put the whole amount into an investment ISA, though the key proviso is that you only have one provider a year; or you could go for a mixture of the two, primarily investing your money in shares and bonds but also having a portion—up to a maximum of half the annual allowance—in cash.
If you opt to make the most of a stocks and shares ISA, selecting your ISA provider is down to personal choice. Both the FSA and the HMRC websites provide details of ISA providers but you could also use a fund platform. This would enable you to keep all your investments in on place and to also benefit from the choice of funds offered by various investment houses via the platform.
At Morningstar, we’re strong advocates of funds because they give you very good diversification--you’re not putting all your eggs in one basket. That may work for the sophisticated investor who's going to pin all their hopes on the recovery of one bombed-out stock, but generally we think big funds are the way forward. Closed-end fund providers are increasingly ISA friendly and Morningstar’s ISA Quickrank can help you research over 4,000 ISA-eligible OEICs.
To help you pick the right funds for you, Morningstar offers two easy filters through our website. The first is the Morningstar Star ratings—these are a backward looking indicator, they’re quantitative and look purely at risk-adjusted performance. The second is our Qualitative Ratings—these are much more forward thinking and aim to tell you what each fund is going to do and how it behaves in the hope that you make the right choices for your funds.
If this is your first foray into investing and you plan to use your ISA as a stand alone investment, then you would do well to look into a global fund--possibly to diversify away from the home bias you have being in the UK. You could consider an asset split between equities and bonds, again to lower some risk. One really easy way to do this would be to use an ETF or a tracker. They’re very cheap, the only risk you are taking on is the market risk, and they’re diversified.
If you’re planning on using ISAs as part of a larger portfolio then you need to assess what it is you’re trying to achieve from those investments. You may want to take some income from the fund later on in life, in which case it would be good to build up that income because, don’t forget, the income will be tax free. In this case you may want to put in your ISA wrapper those funds that you think are going to offer you the highest capital gain over the long run because, again, capital gain is going to be tax free. But you must keep yourself in this long-term mind set—you want to look at least 3-5 years out, if not longer.
