ISAs, Pensions, Investment Bonds and Venture Capital Trusts are all examples of something called an investment wrapper. They do not describe the investment itself. They are in fact the different investment "saucepans" that can be used to hold your various investment "ingredients".
Choosing and making good use of investment wrappers is a key element in our wealth management process.
The section below explains the Bond wrapper.
Investment Bonds are usually a packaged investment product offered by Life and Pension companies.
They offer the advantage of being straightforward in terms of administration and management, and an investor can withdraw up to 5% of the initial investment amount each year, in most cases without paying any tax at that point. They can be particularly useful as investments within a trust.
The rest of this section discusses further the merits and otherwise of Investment Bonds. Many of the tax rules are quite complicated, but they are an important feature of the investment.
An Investment Bond is a wrapper through which one can invest in a very wide range of collective funds. They are offered by the majority of UK Life Assurance companies, and can play a useful role in most portfolios. The funds within an Investment Bond are often known as "life funds". You can usually switch between funds at no cost, and with no capital gains tax implications.
Taxation
Unlike a unit trust, an onshore life fund must pay basic rate tax each year on the income and gains it has earned. This payment of tax has a small negative effect on the growth of the fund each year - a unit trust would be worth slightly more at the end of a year than an identically managed life fund. The longer the fund is held, the larger this difference becomes.
So why put your money in Investment Bonds rather than unit trusts? Well, if you are a higher rate taxpayer, any income and capital gains you make are taxable at the higher rate, but in an Investment Bond, you only pay basic rate tax, or perhaps none at all if the bond is offshore.
Also, you can withdraw up to 5% of your original investment each year for up to 20 years, with no further tax to pay at that point for an onshore bond, even if you are a higher rate taxpayer (although you may have to pay tax later if you withdraw more in the same year or cash the whole investment in).
Investment Bonds give a neatly packaged, easily managed investment solution. However, if you have all of your investments in this type of wrapper, you could be paying more tax than necessary. For example, you don't have the opportunity to use your annual allowance for Capital Gains Tax.
That said, there are good funds that are only available through investment bonds, and quality has to be the main reason for any investment decision.
Trusts
Investment Bonds can be quite suitable for investing money within a trust. Most trusts are now taxable at the higher rate, and have a smaller capital gains tax allowance than an individual. This makes the tax treatment of an Investment Bond quite attractive.
Also, accounting for capital gains and income within a trust can be an additional unwanted burden on the Trustees.
The section below explains the ISA wrapper.
ISAs are simply a tax free wrapper into which you can place either cash or shares. The wrapper can be used to build up a tax efficient rainy day fund, for regular targeted savings or to hold a portfolio of investments including shares, unit trusts and so on.
There is an annual limit on contributions, but from April next year a couple has an allowance of £20,400 per year available for new savings and investments (or to sweep existing investments into the wrapper to save tax).
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Cash ISAs.
If you hold money on deposit in a bank or building society you will pay 20% tax on the interest if you are a basic rate taxpayer. The money will normally be deducted automatically by the government before you see it. For higher-rate taxpayers this increases to 40% and you are required to declare the interest income in an annual tax return.
Cash ISAs are simply savings accounts where the interest isn't taxed. It follows that a standard bank or building society account will have to pay more interest to make up for the tax payable.
For example, for a cash ISA paying 3% AER to be beaten, a basic-rate taxpayer would need a savings account offering over 3.75%, while anyone in the top tax bracket would need a savings account that pays over 5%.
The effects of compound growth over the medium to long term will make a substantial difference, especially if you are a higher rate tax payer.
Just like normal savings accounts there's a variety of cash ISAs available, such as instant access, fixed rate, and accounts with base rate guarantees.
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Stocks and Shares ISAs.
Share based investments in various forms can be held within an ISA wrapper. Shares in individual companies may be placed inside what's called a self-select ISA, which are usually managed by stockbrokers.
However a more common use of the shares ISA allowance is for collective investments like unit or investment trusts. These are pooled investments where a fund manager picks a selection of shares and other asset classes. The value of the investment depends on the collective performance of the shares picked.
Dividend income received by the ISA provider is received net of a 10% tax credit, which is not reclaimable by the ISA provider. Apart from this, there is no tax to pay on the investment either within the fund by the ISA provider or by the individual who holds the investment. This is an important tax break which should be used efficiently if possible.
Over the years since their inception, ISAs have become gradually less complex. Each tax year everyone over the age of 16 has an ISA 'allowance', which sets the maximum that can be saved within the tax-free wrapper from April to April.
The current limit is £7,200, up to £3,600 of which can be in the form of cash. Yet the whole amount could be used for shares if you wish. These limits increased in the April 2009 budget, to £10,200 and £5,100 respectively. When you get the extra tax-free allowance depends on your age...
Anyone who is 50 or over by 5 April 2010 saw their ISA limit increase on 6 Oct 09; this means they can now save that amount for 2009/10, or top up an existing balance that they already had in this tax year.
If you're under 50, you'll have to wait until next tax year (commencing 6 April 2010) to take advantage of the extended limits.
There are three basic scenarios (based on an under 50s ISA allowance):
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Using the maximum cash allowance. You can put £3,600 into a cash ISA, leaving £3,600 available to fill with shares (though you obviously aren't obliged to use this).
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Use it all for shares. You are allowed to invest in £7,200 worth of shares, there will be no tax to pay on the investment.
- Mix n' Match. Some amount under
£3,600 can be saved in cash, then the rest of your £7,200
allowance put in a shares ISA. For example, someone saving
£1,200 in a cash ISA has £6,000 left to invest in shares.
Any savings or investments must be made by 5 April, the end of the tax year.
Crucially, unused allowances (or portions of them) don't rollover; they are lost for good. This means an ISA should always be the first place any savings go, as after the tax year ends, any savings or investments stay within the tax-free ISA wrapper for the future, where they'll continue to earn interest tax free.
A common mistake is to think an ISA needs to be held for a set length of time in order to reap the tax-free benefits. Luckily, that's wrong! Providing the rules of the individual product allow it, you can have full, instant access to your money without losing the tax benefits on the rest of your savings in the wrapper.
However, once the money's withdrawn, it can't be returned. A few examples should help clarify this:
Situation: Mr. Smith is under 50 and invests
£7,200 in a shares ISA at the beginning of the tax year.
Options: He may sell the whole investment, or part of it, at any time without losing the tax benefits, but no more may be bought inside that year's ISA wrapper.
Situation: Ms. Smith, again under 50,
invests £2,000 in a cash ISA at the start of the tax year
Options: She may save a further £1,600 in the cash ISA, or £5,200 in a shares ISA (or a mix of the two) before the end of the tax year.
Situation: Ms. Smith then decides she needs
to withdraw £1,000 of this cash
Options: There's no problem withdrawing the money; for the time the £1,000 was in the ISA the interest it earnt wasn't taxed. However the fact she has withdrawn the cash doesn't increase her allowance at all - she can still only put £1,600 more in the mini-cash ISA, or £5,200 in the shares ISA.
Can I switch provider once I've set up an ISA?
There's nothing stopping you switching providers for cash or shares ISAs; talk to us if you're considering a transfer.
When transferring ISAs, what you can do depends on what type of ISA you want to transfer.
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Current year's Cash ISA. You may move ALL of this to another Cash ISA, or into a Shares ISA. You cannot split it into more than one provider or ISA type.
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Current year's Shares ISA. You may move ALL of this to another Shares ISA, you can't move it to a Cash ISA, or split it between more than one Shares ISA.
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Past years' Cash ISAs. You may move ALL of this to another Cash ISA or into a Shares ISA, or SPLIT it between more than one Cash or Shares ISA.
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Past years' Shares ISAs. You may move ALL of this to another Shares ISA, or SPLIT it between more than one Shares ISA. You may not move any of it into Cash ISAs.
Note, not all ISA providers will accept transfers of previous years' allowances
What happened to Mini and Maxi ISAs?
In the past, ISA rules were unnecessarily complicated, making savers fret about whether to go 'Mini' or 'Maxi'. From the 2008/09 tax year, this was thankfully consigned to history. Yet anyone who had savings in either of these should be aware of what happened when the terms were dropped.
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Did you have Mini ISAs? These were places to hold Cash or Shares separately from each other. If you had a 'Mini Cash ISA', this has now converted into a 'Cash ISA'. If you had a 'Mini Shares ISA', this is now labeled a 'Stocks and Shares ISA'.
- Did you have a Maxi ISA? In Maxi ISAs, the two types of investments were bundled together, and bought from the same provider. Now Maxi ISAs have been abandoned, the cash element will automatically become a 'Cash ISA' and the shares element evolves into a 'Stocks and Shares ISA'.
Personal Equity Plans (PEPs) and Tax-Exempt Special Savings Accounts (TESSAs) were the forerunners to ISAs that existed during the 1980s and 90s. Once ISAs were introduced, these began to be phased out, and in April 2008 any money left in them was moved into the ISA regime.
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TESSAs. These were basically cash-based accounts, and between 1999 and 2004 they turned into TESSA-Only ISAs (Toisas). These have now all become simple Cash ISAs, but possibly at a poor rate of interest. However, all the normal ISA rules apply, meaning you can transfer and potentially get a better rate.
- PEPs. Any PEPS which still exist
have automatically transformed into Stocks and Shares ISAs. You
can continue to invest in them within the rules of normal Shares
ISAs, providing you haven't used another Shares ISA during the
same tax year. It's also possible to transfer funds from the old
PEP into an existing Shares ISA.
Glossary
Footpath Financial Limited is a firm of Independent Financial Advisers who are authorised to advise on and bring about deals in investments. Based in Farnham and Crowthorne we serve the Guildford, Hindhead, Alton, Farnborough and Basingstoke areas. We are Authorised Representatives of the Financial Planning Partnership, who are authorised and regulated by the Financial Services Authority.
