Invest in a tax-free ISA

ISAs are little more than an official tax-wrapper into which other investments may be hidden from the tax-man. Each tax year every adult has an allowance of £7,200 (increased from £7,000 last year and due to increase to 10,200 from next tax-year) and cash, shares, unit-trusts and investment trusts may be held inside this tax wrapper. Cash is treated differently to other investments in that there is a maximum of £3,600 (up from £3,000 last year and due to increase to £5,100 in the 2010/2011 tax year) but if you use the cash allowance, the remainder may be made up of the other types of investment.

Interestingly the changes made to the ISA allowance in the 2009 budget in April are available to anyone over the age of 50, from the date of their birthday.

Apart from the increase in allowance from £7,000 to £7,200 then £10,200 (and £3,000 to £3,600 then £5,100 for cash ISA) the other changes are that now any money held in a cash ISA may be transferred to the equity part of the ISA at any stage in the future. Previously ISAs were far more complicated and you had to either opt for, up to £7,000 in a "Maxi" Equity ISA, or up to £3,000 into a Mini Cash ISA and up to £4,000 in a Mini Equity ISA and then you were stuck with that forever (although Cash ISAs from previous years may also be transferred now) There is a catch however: You cannot move the money back to a Cash ISA at a later stage. You can however keep cash in the equity part of the ISA, but it must be for future investment and is not tax-free. Overall ISAs are now simpler and slightly more useful.

No, Equity ISAs are not completely tax-free, but they are better than almost anything else on the market. Cash ISAs are completely tax-free, in that all interest is paid gross, although you have to check the rates are competitive, because you probably don't want to keep moving your money. The Equity part of the ISA is more complicated in that payments from bond funds (corporate bonds or gilts) are classed and interest and therefore tax-free, whereas true equity investments (share funds: investment trusts; OIECs and unit-trusts) no longer have the dividend tax credit refunded, so tax on company dividends, which are taxed at source, cannot be reclaimed by the ISA to make them truly tax-free (this is complicated and not understood buy most, so Gordon Brown removed this in one of his many "stealth" taxes) This is effectively a 10% tax on dividends.

ISAs are capital gains tax (CGT) free, although there is a personal allowance for CGT of £9,600 for 2008/2009 which means there is no tax advantage unless you are a 40% tax payer, or you are going to make a significant capital-gain.

The cash ISA makes a lot of sense for most people, especially those paying 40% tax, as long as you can get a good rate of interest, as there is no tax on interest. The reason to bother with an Equity ISA, is in time, you really could be hitting the CGT allowance, if you keep trickling money in over many years and don't dip into the fund. You also won't have to worry about declaring gains or dividends and of course, if you do pay 40%, it makes a huge difference, because an additional dividend tax would otherwise need to be paid. If you don't use your annual allowance, you will lose it and in general it is no more expensive to hold investments inside the ISA than outside. Investing in corporate or government bonds is still tax-free inside an ISA and also makes a lot of sense for everyone (they are generally safer than shares, but over the long term tend to pay out less)

What can I invest in?

You can invest in unit-trusts, investment trusts or individual shares. Investment trusts are my favourite equity investment. I have also reviewed these here, but they are shares in investment companies and generally have lower charges and better performance than unit trusts, which are often recommended by advisors (investment trusts do not pay commission to advisors, so they are unlikely to recommend them) There are hundreds of investment trusts and thousands of unit-trusts to choose from, ranging from UK larger companies or low-risk bonds to emerging markets and Japanese smaller companies, gold, mining and commodities. If buying unit-trusts for your ISA it is best to buy the ISA from a "fund supermarket" or discount broker, who will return most of their commission in the form of a discount (e.g. www.moneysupermarket.com or Hargreaves Lansdown) Individual shares are riskier and should be treated with care. It can also be expensive in charges to build up a diversified portfolio of individual shares.

For people with large sums of money willing to take a lot of risk there are EIS and VCT schemes (Enterprise Investment Schemes or Venture Capital Trusts) which allow reduction in capital gains tax liability and other tax advantages, in exchange for investing in start-up businesses, but there are a few alternatives for the ordinary investor too. National Savings and Investments (NS and I) have a few tax-free products: Premium bonds, reviewed by me in the past, which are tax free, but with fairly low return; Fixed Interest Savings Certificates, which pay out a fixed but low, tax-free rate for three or five years and Index Linked Saving Certificates, which at the moment look rather good, paying 1% plus RPI inflation rate (currently heading up towards 5%) tax free. All NS and I products are completely backed by the government. The Savings Certificates have a limit of £15,000 per issue of which there may be two 3-year and two 5-year certificates per year and they can be rolled over at the end of the period, so theoretically you could invest £60,000 tax free per year, in index-linked certificates (not a lot of people know that)

Another alternative to the ISA is the Personal Pension which have the tax advantage that income tax at your marginal rate, is refunded (20% rebate for everyone and the remainder claimed back through the tax return for higher-rate tax payers) Dividends inside a pension are taxed at 10% as with ISAs and Pension income is taxed at a later date when you take your pension, whereas ISAs are not. You can take a tax-free lump-sum at retirement of 25% of the fund, but you cannot take any money out at any stage until then (and there is no guarantee that the government won't change the minimum age - currently 55, increased recently from 50)

I certainly think these are a good idea. Probably the best deal you can get for equities and definitely for bonds. Equity investment is risky, but no more risky in an ISA than outside. As for cash, I prefer to use NS and I index-link savings certificates at the moment, although this is more restrictive, but for most people Cash ISAs are an extremely good deal too.

Summary: One of the best tax schemes available at the moment

UK Specific

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