Individual Savings Accounts (or ISAs as they are more commonly known) have become one of the most tax efficient ways to make regular, long-term savings. Introduced in 1999 by the Labour government, they replaced PEPs and TESSAs.

What Exactly is an ISA

Commonly, investors believe that ISAs are investments in their own rights, such as shares or bonds. This is not actually the case; an ISA is simply a 'wrapper' that enables a company, often a bank or building society, to place other investment types such as shares or cash into the ISA in order to offer a tax free saving.

ISAs are offered in two key different types of instrument, namely cash and shares; most people will see references made to 'mini cash ISAs' as well as traditional 'share ISAs'.

The Basic Workings of an ISA

Quite simply, an ISA is a savings account where the interest accrued does not attract income tax. Therefore, if you are a higher rate tax payer who would normally pay tax on interest achieved at the 40 percent tax rate, placing your cash savings in an ISA will allow you to receive any income generated free of tax.

As an ISA is merely a type of account, there is a huge range of rates available depending on the specific account you select. An instant access ISA will generally produce a much lower rate of return than an ISA that is fixed and does not allow withdrawals for a long period of time.

Mini or Maxi

When investing in an ISA, you will have to decide whether you want to invest in a Mini ISA or a Maxi ISA. A good way of remembering the difference is that if you want to maximise your share holding as part of an ISA, then you will be looking for a Maxi ISA. If you wish only to maintain a cash-based investment, then you will be better off opting for a Mini ISA.

With a Maxi ISA, all products have to be purchased from one provider. Therefore, if you are purchasing both cash and shares, they will both have to come from the same company. In this case, the entire amount of your annual investment could be held in shares. With a Mini ISA, it is possible to purchase the cash and shares from two different sources.

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Investing in an ISA

Putting money into an ISA is a straightforward matter of selecting the most appropriate account for your needs and then transferring the cash from your other account into the ISA, just as you would with any other transfer.

Every tax year, any individual over the age of 16 may invest up to £7000 in an ISA, although only £3,000 of this can be in cash. Typically, with a Maxi ISA, the investor will put the entire £7,000 into shares; with a Mini ISA it is more common for a cash ISA to the value of £3,000 to be taken with one provider and a further £4,000 invested in a share ISA, which may or may not be with the same provider.

The maximum that can be invested in any one tax year is £7,000. It is common practice for those who are in a position to save, to place £3,000 into a cash ISA, immediately at the beginning of a new tax year. Many investors will also take a share ISA to make up the entire balance. As all gains made to the value of the ISA are tax free, this is a very efficient way to save, particularly for those who are in the higher income tax bracket and would otherwise be charged 40 percent on any investment income.

Managing an ISA

ISAs are remarkably flexible and are available to suit just about every investment need. As an ISA is simply a wrapper bank account, each will have its own terms and conditions. Some of the accounts are for a fixed period of time and offer generally favourable rates although, normally, they also incur penalties for early withdrawal. Other accounts allow withdrawal at any time but may not offer the same interest rate returns.

Withdrawing from an ISA

A common misconception about ISAs is that there are tax penalties for early withdrawal. This is not actually the case and any income received prior to the withdrawal will be tax free. Where the penalty does come into play, however, is in relation to the saving limit of £7,000. This limit refers to the amount that is PAID IN and does not take account of any withdrawals. Therefore, if you open a cash ISA of £3,000, at the beginning of the tax year, and then withdraw say £1,000 a few months later, you will not be able to ‘top’ up the amount to £3,000 at any point during the tax year.

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Introduction to ISA Planning

It is not uncommon for investors to put their entire allowance into the best account offering, every year, and then to neglect the longer term implications of this saving. A definite tendency exists simply to plough the investment into whichever account is the most convenient, without much further consideration. Although the most important factor is that the investment is made in the first place, much more can be achieved in terms of financial gain and stability by actually considering the long-term strategy of your ISA portfolio.

Pure Cash Savings

The vast majority of people invest purely in cash ISAs of £3,000 a year. This may be because investing in a cash ISA is seen to offer a straightforward and favourable savings account, whereas investing in shares is viewed as more risky, in some way. With this in mind, reviewing one’s portfolio of cash ISAs should be an annual consideration.

The best interest rates are almost invariably offered for accounts that are either for a fixed period of time or accounts that have a set notice period for withdrawal. Anyone who is able to invest regularly should consider having at least half of their portfolio as long-term. By maintaining a long-term approach with at least some of the ISA savings, the best rates can be obtained. One common approach is to invest cash in a fixed term ISA of approximately 5 years and to do this every year for 5 years. This way, every year, a sum of cash will be released that can then be re-invested into further ISAs.

Share Based ISAs

Share based ISAs require a little more thought because although the principles remain the same as with a cash ISA, the investment choices are potentially much greater. It is possible to invest the full £7,000 allowance in share based ISAs, which offers a better investment opportunity than a £3,000 cash investment.

When selecting the best share ISA, there is more to the decision than the simple interest rate. In fact, with a share ISA there are no interest rates offered; instead, you will have to make a strategic decision. For example, do you want to make a low risk share investment in entities such as Blue Chip companies or would you rather invest in riskier entities such as emerging markets

As with a traditional share investment, it is important to recognise that the value of the investment can go down as well as up; riskier investments may return a greater financial benefit but also are more susceptible to significant losses.

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Pension or ISA

In reality, the answer for most people would be both, if at all possible. However, for those trying to maximise their financial potential, it pays to understand fully the tax and long-term implications of both types of investment, so that you can make the best decisions for your personal circumstances.

Why the Question

Everyone knows that pension saving is tax free, so why are we even asking the question Consider this: when a pension investment matures, only 25 percent of the proceeds, i.e. the lump sum, is actually available, tax free. All other pension amounts are taxed at the marginal rate, which means that the tax break is only actually 5.5 percent for a basic tax payer and 10 percent for a higher rate tax payer.

For example, if a higher rate tax payer has a pension saving of £100,000 then 25 percent of the amount (£25,000) is tax free and the remaining £75,000 taxed at 40 percent. This means that the total tax payable on the £100,000 is £30,000. Consequently, the higher tax rate payer pays tax on their pension of 30 percent, a relief of 10 percent.

Therefore, it is easy to see why those who have explored the full pension calculation are considering investing in ISAs, which are truly tax free.

The Maths

Let’s look at two different investors, both with £7,000 to invest. One invests in an ISA and the other in a pension scheme. The pension investor automatically sees their £7,000 investment grossed up to a total of £11,666, assuming that the person is a higher rate tax payer. When the pots mature, let’s assume that they have both doubled in value so that the ISA is now worth £14,000 and the pension is worth £23,333.

Looking first at the pension pot, 25 percent of this can be taken tax free which amounts to £5,833; the rest is taxed at 40 percent, which means that the remaining amount of £17,500 incurs a tax liability of £7,000. The total amount, therefore, that is available is £16,333. The ISA, on the other hand, would be worth £14,000.

This strict comparison shows that the pension route appears the more cost effective. Bear in mind, however, that the balance of the pension pot (in this instance of £10,500), would have to be invested in an annuity to produce an annual income. These annuities are often at very poor rates, whereas with an ISA the entire £14,000 can be withdrawn and used as the investor chooses; there are no restrictions on what should be done with the proceeds.

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