It’s that time of the year again, the end of the British tax year when savers and investors rush to top up their ISAs ahead of April 6th. If you want to take advantage of your full allowance for the 2011-2012 tax year--£10,680--now is the time to do it.
What Is an ISA?
An ISA is an individual savings account. British residents use ISAs to avoid paying tax on money held within these accounts. You can hold cash, shares, unit trusts, investment companies, ETFs and/or bonds in an ISA. The main benefit of having an ISA is that your money is more or less immune from taxes. You avoid paying income tax on interest and dividends, and you avoid paying capital gains tax on portfolio gains.* ISAs were created by the government in 1999 to promote a savings culture in the UK.
There are two kinds of ISAs: a cash ISA and a stocks and shares ISA. A cash ISA will, predictably, hold cash. Cash ISAs available for investors generally offer a set interest rate, so you know that, for example, if you put £1,000 in a cash ISA offering a 3% interest at the beginning of the financial year, this will have increased to £1,030 at the end of the year.
Meanwhile, a stocks and shares ISA is designed to hold stocks and shares, as well as bonds and other kinds of investments. Returns within this kind of ISA will be more unpredictable, but give investors the opportunity to receive higher returns.
A key thing to remember is that an ISA is just a tax-efficient wrapper, you still need to make choices about how you manage your money inside that wrapper.
(*Note, that ISAs are not completely tax immune. Dividends generated from equity, both inside and outside an ISA, will automatically have a 10% tax skimmed off the top by the government. If you're a higher rate taxpayer you would normally pay tax on dividend income at 32.5% or 42.5%, but inside an ISA you only have to pay 10%. This 10% tax only applies to equity dividends. It does not apply to income paid by corporate bonds or gilts within ISAs.)
Who Can Invest in an ISA?
UK residents can invest in ISAs. UK citizens living abroad can continue to hold and receive tax relief on existing ISAs but cannot make new investments whilst living abroad. Crown employees who are serving overseas are an exception to this rule: they and their spouses may continue investing in their ISAs as per usual.
Why Should I Have an ISA?
If you are saving for a specific near-term goal, such as a new car or deposit to buy a house, cash ISAs are a helpful tax-efficient savings tool that ensure you can make a bit of money each year to pay for what you want. Even if you’re only putting a small amount into a cash ISA, the rates you receive within an ISA will likely be much better than any rates you would receive outside an ISA.
For longer-term goals, such as saving for retirement, you could invest in stocks and bonds. This is riskier, because you could lose some money in the short-term if your investments do not perform well. However, in the long term, this option gives you the potential to make higher returns than cash. 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.
Yvonne Goodwin, managing director and independent financial advisor at Yvonne Goodwin Wealth Management, currently helps one couple manage an ISA portfolio of £500,000 that is generating roughly £24,000 in tax-free income every year. They don’t have to declare this income at all because it’s generated inside an ISA, says Goodwin. This proves that a disciplined approach to ISA investing can—literally—pay huge dividends in the future. (Note: Income within an ISA can either be reinvested, or funnelled straight into a personal account for immediate use.)
How Do I Invest in and Manage an ISA?
The maximum that you can put into an ISA for the 2011-2012 tax year is £10,680. Each tax year runs from April 6th until April 5th of the following calendar year. For the 2012-2013 tax year, the investment limit will rise to £11,280, in line with the Retail Prices Index.
You can own a cash ISA, which can hold up to £5,340; or you can put the whole amount into an investment ISA. Alternatively, you could go for a mixture of the two, primarily investing your money in shares and bonds but also having a portion—up to half the total annual allowance—in cash.
Each year you can subscribe to one cash ISA and one stocks and shares ISA. You cannot subscribe to more than one cash ISA or more than one stocks and shares ISA in the same tax year. However, you could feasibly open multiple ISAs over multiple years, and you do not need to stick with just one ISA provider.
If you want to transfer your ISA to a different provider, you must arrange this directly with your current provider and you should check about any potential charges for transferring. You cannot arrange a transfer on your own by closing your first ISA and opening a new one. You can also move money from your cash ISA into a stocks and shares ISA, but the money cannot be moved the other way around, from stocks and shares to cash.
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 one place and to also benefit from the choice of funds offered by various investment houses via the platform.
How Can Morningstar Help Me Make ISA Decisions?
At Morningstar, we’re strong advocates of investing in funds (OEICs, closed-end funds, ETFs, etc) because they help you diversify your portfolio--you’re not putting all your eggs in one basket. Closed-end fund providers are increasingly ISA friendly while Morningstar’s ISA Fund Quickrank can help you research over 4,000 ISA-eligible OEICs.
To help you pick the right investments, Morningstar rates funds and stocks using three easy-to-use ranking systems:
- The Morningstar Star Rating system for funds gives ratings based on how well a fund has performed compared to its peer group over the past three years. The system also adjusts for risks, giving riskier funds lower star ratings. While a high star rating is promising, this is not a sufficient basis for investment decisions, since the star rating is only based on past performance.
- Morningstar also has Star Ratings for stocks and shares, but these ratings operate slightly differently compared to Star Ratings for funds. Morningstar’s Star Rating for stocks tells you whether our analysts think a stock is under- or over-valued by the market. So if a stock has five stars, this would indicate a potential buying opportunity, but if a stock has just one star, this would indicate our analysts think the market is overvaluing that stock. Click here for more details.
- Morningstar Analyst Ratings are qualitative, forward-looking ratings that provide investors with our independent view on what role a fund should occupy in a portfolio and how successful it might be at achieving its goals. Analysts give these ratings—Gold, Silver, Bronze, Neutral and Negative—based on in-depth analysis of a fund’s strategy, fees, managers, performance and provider. These ratings are not used for stocks.
