What is a stocks and shares ISA?
An ISA (individual savings account) is essentially a wrapper into which you can put a range of investments to protect them from tax.
There are two types: a stocks and shares ISA, and a cash ISA.
Cash ISAs are like any other standard savings account, but with one fundamental difference: you don’t pay tax on any interest you earn.
Returns on stocks and shares ISAs are also tax-free but there is a much greater choice of what you can invest in. Investment funds, individual shares and bonds, and exchange traded funds can all be held within a stocks and shares ISA.
Every adult in the UK is allocated an ISA allowance each tax year. The tax year runs from 6 April to 5 April – if you don’t use your annual allowance during that time, it is lost forever. You can’t carry it over to the following year.
For the greatest tax savings, it therefore makes sense to invest the maximum each year – and watch your tax-free nest egg build up with time.
How much can I invest?
Currently anyone under the age of 50 can invest up to £7,200 in an ISA. The allowance is £10,200 for anyone who will be 50 or over, on or before 5 April 2010. All adults will benefit from the higher annual allowance when the new tax year starts on 6 April 2010.
You can either invest the full allowance in a stocks and shares ISA or split it – up to 50% can be invested in a cash ISA. Splitting the allowance between cash and equities is a popular choice with many people.
Rule changes introduced in 2008 also mean that you can move money held in existing cash ISA into a stocks and shares ISA and retain the tax break. However, you can’t transfer money from stocks and shares into a cash ISA.
ISAs are aimed at encouraging people to invest for the longer term – as soon as you make a withdrawal from an ISA you lose the tax-free status on that money. Therefore, if you need to dip into your savings, use funds held in non-ISA accounts first.
Is a stocks and shares ISA suitable for me?
The advantage of investing in a stocks and shares ISA is that you can shelter more money from the taxman than if you just put your money in a cash ISA. The reason for this is that the government wants to encourage more people to invest in equities because, over time, they tend to produce higher returns than cash. And obviously, the more money individuals can save for their own futures, the less reliant they’ll be on the state.
However, there is more risk attached to a stocks and shares ISA because stock markets can go down as well as up, so you could lose money.
Financial advisers therefore only tend to recommend that you use a stocks and shares ISA if you have money you are looking to invest for at least five years. That way you should be able to ride out dips in the stock market. Having said that, even then there is no guarantee, so if you are totally risk averse, a stocks and shares ISA probably isn’t for you.
It is also important to understand that there is a huge variation in the types of investment you can hold within a stocks and shares ISA – some are more risky than others and returns will vary significantly.
Aim to diversify
Most people use their stocks and shares ISA allowance to invest in funds, as opposed to buying shares or bonds in individual companies. The reason for this is that a fund gives you exposure to a large number of companies which helps reduce some of the risk attached to your investment. If your money is spread between lots of different companies, you are less reliant on the share price of a single firm doing well in order get a good return on your investment.
Also, you don’t have to invest your entire ISA allowance in one fund. You can spread the risk further by investing in a number of funds and they don’t have to be from the same provider. For example, if you are under 50 and wanted to invest your full £7,200 allowance in a stocks and shares ISA, you could split the money between a few funds.
What should I invest in?
There are literally thousands of funds to choose from, investing in different stock markets, different types of companies or sectors and even different asset classes. For example, UK large companies, UK corporate bonds, emerging markets, technology stocks, commodities and commercial property.
Not only can the breadth of choice be quite daunting, but the way the funds perform will also vary significantly so it’s really important to do your research before deciding where to invest.
Ideally, you should look to build up your own investment portfolio giving you exposure to different types of funds as diversification helps spread the risk. This can be done over a number of years but it will obviously depend on how much money you have to save and how much risk you are prepared to take.
Don’t worry if you can’t afford to use your ISA allowance every year – it doesn’t rule out investing in a stocks and shares ISA. In fact, the sheer number of funds available means there is pretty much something for everyone.
Advisers tend to recommend that first-time equity investors stick with a UK-based fund rather than going for a fund that invests in overseas shares.
If you already have money in stocks and shares ISAs, look at what it is invested in and use this year’s allowance to diversify further.
There are lots of online investment tools and research guides on sites such as Hargreaves Lansdown which can help you work out which fund to go for. Alternatively, speak to a qualified financial adviser for specific advice and recommendations.
How do funds differ?
As mentioned above, there is a huge choice of investment funds. But as well as the fact the underlying holdings differ, the other key point to note it that there are two main types of fund: active and passive.
Passive funds - Index trackers: The cheapest way to invest in equities is to go for an index tracker fund. These are known as ‘passive funds’ because they aren’t run by a manager. Instead they are directly linked to a stock market index. For example, if you invest in a FTSE 100 tracker, you will have exposure to all 100 companies in the FTSE 100 and the value of your investment will move in line with the market.
There is no initial charge to invest in this type of fund but you will pay an annual fee of up to 1.0%.
Because this type of fund tracks an index, you can never outperform the market. In fact the annual fee means your return will always be slightly lower.
Active funds: If you invest in an actively managed fund, the fund manager will decide which companies they want to invest in based on where they perceive the best opportunities to be, and buy and sell holdings as they see fit.
This doesn’t mean they can invest in any firm they want – there are restrictions depending on the type of fund. For example, if it’s a UK Smaller Companies fund, the manager will only be able to invest in companies listed on that index.
However, because the manager can pick and choose which shares to buy and sell, you should, in theory, be able to get a better return from an actively managed fund than an index tracker. If the manager gets it right, he or she should be able to outperform the index.
This isn’t guaranteed, however, and some managers are better than others. Just as there is the potential to beat the index, there’s also the potential to underperform the index.
Also, fees are higher on actively managed funds as you are paying for the manager’s expertise.
You will be charged an initial fee when you first invest of up to 5.5%. However, this could be lower if you invest via a fund supermarket or discount broker, as they are able to negotiate discounts on many initial charges.
There will also be an annual management charge of between 1.0% and 1.5%.
Is there anything else I should know?
Unlike a cash ISA, stocks and shares ISAs aren't completely tax-free. Buying share-based investments through ISAs only saves you tax if you're a higher-rate taxpayer, or are likely to pay capital gains tax.
However, if you use your stocks and shares ISA to invest in interest-bearing investments, such as corporate bonds, the interest is tax-free whatever tax band you fall into.
Lower-rate taxpayers should therefore opt for investments of this kind to get the most out of their ISA.
It is also worth pointing out that ISA income does not need to be declared on your tax return.