David Harrowven looks at current ISAs and their advantages, limits, and regulations
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Individual savings accounts (ISAs) were introduced on 6 April 1999, replacing tax-exempt special savings accounts and personal equity plans. The structure of ISAs has since been simplified so that just cash ISAs and stocks and shares ISAs are now available. In 2011-12 alone over 14 million adult ISAs were opened (although this was some one million less than the previous year), of which around 80 percent were cash ISAs - with approximately GBP54 billion invested. The introduction of junior ISAs has extended availability to children.
Interest, bonuses and dividends received are free of income tax, although the 10 percent tax credit on dividends cannot be reclaimed. Gains are free of capital gains tax, although the benefit of capital losses is lost. If cash is held within a stocks and shares ISA awaiting investment, then there is a flat rate 20 percent charge on any interest earned - but this is not income tax as such.
The tax advantages are obviously greater for people paying tax at the higher rates. For example, the best interest rate currently available (April 2013) for an instant access cash ISA is around 2.3 percent, although slightly higher fixed rates are available if investment is made for a fixed period. This is an effective gross rate of 3.83 percent for a higher rate taxpayer, and 4.18 percent for an additional rate taxpayer.
Funds can be withdrawn from ISAs at any time without the loss of tax relief, although the interest rate for many cash ISAs includes a bonus that is only payable if the investment is left untouched - typically for 12 months. And normally where investment is made for a fixed period, withdrawals will result in the loss of interest.
It is not necessary to declare income and gains received from ISAs on a self-assessment tax return. ISA income does not result in the loss of the higher personal allowances available to those born before 6 April 1948, or the normal personal allowance for those with income in excess of GBP100,000. ISA income is also not included for tax credit or universal credit purposes.
Only individuals can open ISAs (they cannot be held jointly by spouses or civil partners, held on behalf of anybody else, or held in trust), and normally an individual must be resident in the UK. If someone goes to live abroad then they can keep their existing ISAs, but cannot pay in any more money. ISAs cease to be tax-exempt from the date that an individual dies, and the tax exemption does not extend to inheritance tax - they form part of a person's estate.
The minimum age limit for cash ISAs is 16, and for stocks and shares ISAs it is 18. However, if a parent contributes towards a cash ISA held by a child aged 16 or 17, then the income can potentially be taxed as the parent's and therefore not be tax-free.
Junior ISAs can be opened by parents for children under 18 who do not have a child trust fund - most children born between 1 September 2002 and 2 January 2011 will have a child trust fund. Anyone can contribute towards a junior ISA, including parents, family members and friends. In the case of parents, the income will always be treated as the child's. No withdrawals are normally permitted until a child reaches 18, and at that age a junior ISA will automatically convert to a normal ISA.
Each tax year an individual can open one cash ISA and one stocks and shares ISA. For 2013-14 the cash ISA investment limit is GBP5,760 and the stocks and shares ISA limit is GBP11,520. The overall investment limit is GBP11,520. Therefore if a cash ISA is not opened the full limit of GBP11,520 can be invested in a stocks and shares ISA. If a cash ISA is opened then only the balance remaining of the GBP11,520 limit can be invested in a stocks and shares ISA. The ISA investment limits increase each year in line with the consumer price index.
A problem can arise where someone opens a cash ISA but does not invest the full GBP5,760. This is because many fixed rate ISAs do not permit the account to be topped up, whilst others do not allow further investment once they have been taken off the market. Surprisingly, HMRC seem to turn a blind eye to investors opening a second cash ISA in order to utilise the balance of their investment limit, provided they are not repeat offenders.
With junior ISAs the overall investment limit for 2013-14 is GBP3,720, but this can be slit between a cash junior ISA and a stocks and shares junior ISA as desired. However, it is only possible to hold one cash junior ISA and one stocks and shares junior ISA at any one time. It is not possible to open new accounts each year.
Somewhat surprisingly, there is no interaction between junior ISAs and normal ISA investment limits. Therefore, someone aged 16 or 17 can benefit from both the overall junior ISA limit of GBP3,720, and the normal cash ISA limit of GBP5,760.
The investment limits are once only - for example, if GBP5,760 is put into a cash ISA during 2013-14 and then GBP2,000 is subsequently withdrawn, it is not then possible to make any further investment during 2013-14.
The deadline for using the 2013-14 ISA allowances is 5 April 2014. If an individual opens both a cash ISA and a stocks and shares ISA then they can either be with the same provider or with different providers.
The investment in a cash ISA will normally be in the form of a cash deposit with a bank or building society, although NS&I also offers a direct cash ISA.
Within a stocks and shares ISA it is possible to hold any shares listed on a recognised stock exchange anywhere in the world, government and corporate bonds, unit trusts, open ended investment companies (OEICS) and investment trusts, but not unquoted shares, shares listed on the alternative investment market (the government is consulting on including shares listed on the AIM, possibly from 2014/15), options or futures.
However, many ISA providers only offer a limited choice of investment funds - often just the funds managed by the provider itself. To have access to the full range of qualifying investments it will probably be necessary to have a self select ISA with a stockbroker, and even then the choice may be restricted, for example, to just FTSE 350 companies.
Subject to certain conditions, shares can be transferred into an ISA from a HMRC approved employee share scheme, but it is not possible to transfer windfall shares or inherited shares since subscriptions must be in the form of cash. It is also possible to hold certain life assurance policies within a stocks and shares ISA. Cash can only be held pending future investment.
With minor exceptions, the same range of investments are permitted in junior cash ISAs and junior stocks and shares ISAs.
Various transfers are possible:
- Money in an existing cash ISA can be transferred to a cash ISA with another provider. This may be to obtain a better rate of interest, or maybe to consolidate various old ISAs into just one account.
- Money in an existing cash ISA can be transferred to a stocks and shares ISA either with the same provider or a different one. If the cash ISA being transferred is for the current tax year, then it is treated as never having existed. For example, during 2013-14 GBP4,000 is put into a cash ISA, and this is then transferred to a stocks and shares ISA. The full GBP5,760 cash ISA limit is still available for 2013-14.
- Investments in a stocks and shares ISA can be transferred to another stocks and shares ISA with another provider. This assumes that the new provider will accept the investments that are held in the existing ISA, which will often not be the case if only a limited range of investment funds are offered.
When swapping ISA providers, transfers must be made directly between the two ISA managers. If an ISA is closed and then reinvested it will use up the investment limit for the current year. Transfers do not affect the investment limits for the current year.
It is not possible to make a transfer from a stocks and shares ISA to a cash ISA.
The rules are more flexible for junior ISAs since it is also possible to make a transfer from a stocks and shares junior ISA to a cash junior ISA. However, when making transfers the restriction that only one account of each type can be held at any one time must be complied with - so if money in an existing cash junior ISA is transferred to a new cash junior ISA, all of the funds in the existing account must be transferred.
It is not currently possible to transfer the savings in a child trust fund to a junior ISA, although the Government is consulting on whether such transfers should be allowed. No changes are expected before April 2014.
The right choice?
There are normally no charges involved with a cash ISA, but an individual must be careful and not just focus on the tax saving. A survey in 2011 found that the Halifax was paying gross interest of 3.35 percent on its one year fixed rate bond, but just 2.00 percent on a similar cash ISA. Even higher rate taxpayers would have been marginally better off with the non-ISA account (3.35 percent less 40 percent income tax is a net return of 2.01 percent).
A review of some of the savings accounts currently offered by some of the major high street banks and building societies indicates that this is generally no longer the case - the Halifax is actually paying higher rates on its fixed rate cash ISAs compared to similar non-ISA accounts. Generally, cash ISAs are probably the right choice for everyone except for non-taxpayers, although it pays to shop around as interest rates vary widely between providers.
It can be much more difficult in deciding whether a stocks and shares ISA is the right choice. Charges will vary according to the type of investment, and also between providers. For example, the annual management fee for a self select stocks and shares ISA with GBP20,000 invested can vary between nothing and GBP120. However, for many fund type ISAs the charges may be no higher than if the investment was made outside of any ISA. The additional charges incurred by holding investments within an ISA must be compared to the potential tax savings.
As far as income tax is concerned, there is no benefit to receiving dividends within a stocks and shares ISA for basic rate taxpayers as the tax credit cannot be reclaimed. There is no capital gains tax benefit if gains would otherwise be covered by the annual exempt amount (currently GBP10,900).
Stocks and shares ISAs will therefore be most appropriate for higher and additional rate taxpayers who already have sufficient gains to make use of the annual exempt amount. In addition to avoiding the higher or additional rate income tax liability on dividend income, they will also save capital gains tax at the higher rate of 28 percent.
However, a stocks and shares ISA may be appropriate for a basic rate taxpayer where they invest in interest bearing investments such as corporate bonds, since interest received will be tax-free - saving tax at 20 percent.