Isa 'dribble' ignores the tax incentives

Published on Friday 20 March 2009 19:20

WITH cash rates at all-time lows and market volatility showing little sign of letting up, money is merely dribbling into Isas as the tax year comes to an end.

But the difficult climate arguably makes the tax efficiency of Isas more valuable than ever.

The maximum that can be paid into an individual savings account (Isa) in the current tax year is 7,200, of which up to 3,600 can be paid into a cash Isa. The same amount can be paid into a stocks and shares Isa, or the full 7,200 allowance. Gordon Brown recently signalled a possible hike in the limit in the Budget on 22 April in a bid to boost savers after a torrid few months, although the extent of a potential rise is unclear.

There is still time to use this year's allowance and although the crisis has deterred many people from doing so, the opportunity for growth unimpeded by the taxman is not to be sniffed at. So here are a few simple tips to help you get the best out of your Isa savings and investments.

Tax breaks

The great advantage of Isas for both higher and basic-rate tax payers is that no capital gains tax and no additional income tax are payable. This is especially meaningful for higher-rate taxpayers, as dividends are taxed at just 10 per cent rather than the 32.5 per cent on non-Isa investments.

The difference the tax treatment makes to savings is also significant. Birmingham Midshires pointed out that on the average balance of 2,426, a 3 per cent cash Isa generates 73 in annual interest. In contrast savers would need a 3.75 per cent rate from a non-Isa account to match that return. At the time of writing, however, the best instant-access savings rate was just 2.45 per cent.

Regular savings

A growing number of frustrated savers are casting off their shackles and opting for equity Isas in search of tangible returns. According to fund supermarket Interactive Investor, while 48 per cent of those who took out an Isa in the 2007-8 tax year opted for a cash Isa, just 32 per cent of those who intend to take out an Isa in the current tax year will take the cash route.

Ken Taylor, director of Mackenzie Taylor Wealth Management, said: "Don't forget that cash Isas can now be transferred into stocks and shares Isas. There are many investors with considerable balances held in such holdings which will now be suffering from vast reductions in interest rates."

For investors nervous about committing lump sums to markets, especially in the current environment, the regular savings argument is compelling.

"A long-term view is required with any equity investment and it is 'time in the market' that will deliver superior returns rather than 'timing of the market'," said Derek Smith, a director of IFA Melville Hutchison in Edinburgh.

One benefit of drip-feed investing is the effect of pound cost averaging. This refers to the fact that when markets are low, your money is buying more shares at the lower price. It also reduces the impact of market volatility, because the extra units bought at the lower price bolster the value of the investment when markets rebound.

Charges

Many investors underestimate the extent to which fund charges erode returns.

"Often overlooked, charges can make a huge difference to your long-term returns, particularly in an investment environment of single digit returns," said Smith. "Many funds have total costs of as much as 2.5 per cent a year and that makes a big dent in a fund that might only return 8 per cent over the long term."

Most funds advertise the initial and annual management charges, but the key figure to look out for is the total expense ratio (TER), giving the total amount charged annually.

Investment trusts typically levy lower charges than unit trusts and tend to have TERs of around 1.4 per cent.

The compound impact of high charges on returns can be considerable. For example, a 10,000 investment growing by 7 per cent a year in a fund with a TER of 1.5 per cent would reach 17,081 after ten years, but only 14,800 with a TER of 3 per cent.

Fees can also be reduced by going through a fund supermarket or discount broker.

Diversification

Millions of investors have paid the price for flocking into heavily promoted flavour-of-the-month fads in recent years, such as commercial property and technology funds. This tends to be at the expense of diversification, which refers to spreading investments across different asset classes – usually cash, equities, fixed-interest and property – to achieve a degree of non-correlation. Within equities it means investing in a cross section of regions, sectors and stocks.

While diversification may not prevent investors from losses – especially last year when the asset classes correlated to a rare degree – history shows that balanced portfolios have coped better in adverse conditions.

The extent to which investors are exposed to the different assets depends on risk appetite and time to retirement.

"Take time and seek advice where necessary in order to build a portfolio that takes account of existing investments and your appetite for risk," advised Smith.