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What is an ISA?

Individual Savings Accounts allow you to shield cash or investments from the taxman - read our beginner's guide to find out how to make the most of your allowance

Emma Wall 6 March, 2017 | 12:40AM

 

Individual Savings Accounts (ISAs) are strictly speaking not investments themselves but wrappers which allow investments to be made tax free. By putting money into an ISA it is possible to shelter various kinds of investment from the need to make capital gains tax (CGT) or income tax payments.

In July 2014, the New ISA (NISA) was launched allowing investors more flexibility to move their tax-free lump sum between investments and cash. The annual allowance was also increased to £15,000. The ISA allowance is usually raised at the start of each new tax year, and in April 2016 it increased to £15,240. From April this year, you will be able to shield £20,000 a year in an ISA.

A failure to distinguish between the ISA wrapper and the investment itself causes a lot of unnecessary confusion about ISAs among new investors. If the two things are seen as separate – although related – it is much easier to understand how they work. 

When someone is “putting money into an ISA” they are actually doing two things at once. They are investing in some kind of financial asset and putting a wrapper around it to protect it from the taxman.

So any investments made within the ISA are, subject to various annual allowances, tax free. For example, an investor who wanted to put money into assets that paid out income in the form of dividends or interest could quite legally avoid income tax. Any investments made within the ISA wrapper would not need to be declared to the taxman. 

Similarly an investor who expects his investments to rise significantly in the near future or further ahead could use an ISA to protect himself from paying Capital Gains Tax. CGT is liable where you make a gain of more than your annual allowance – currently £11,100 a year.

But if an investor builds up a portfolio of investments within an ISA wrapper they are not liable to pay CGT. This can result in a significant tax saving as after your allowance; CGT is paid at a rate of 28% for higher tax earners and 18% for those who pay the basic rate of tax. 

Most assets can be shielded in an ISA wrapper, including cash in a savings account, stocks, bonds, open-end and closed-end funds as well as life assurance policies and ETFs.

Funds are a pool of assets which can be actively managed by a fund manager or passively run when a basket of assets tracks an index.

The main advantage of investing in a fund – as opposed to holding individual shares – is that composite funds enables investors to diversify risk more easily. So, for example, if the share price of one company in a portfolio falls it has a limited effect on the fund as a whole.

Even the most experienced investors with a large investment portfolio would find it difficult to achieve the same diversity, access and economies of scale as asset managers.

Open-end fund and investment trust investors do face higher costs by turning over the management of their portfolio to various fund managers but in return they do not need to be knowledgeable about markets nor constantly monitor their investments. The fund manager will make the day-to-day decisions and make sure that risk is properly diversified, for these reasons pooled funds are often a better choice for new investors than individual shares.

 

ISA Terminology 

Active fund: A fund managed by a professional fund manager

Bond: A form of debt issued by a company (corporate bond) or government. Bonds issued by the British government are known as gilts
CAT (charges, access, terms) standard: A voluntary standard set by the Government to indicate that they are simple, clear and fair. Those ISAs that invest in the stock market can charge investors a maximum of 1% of their assets per year. This standard should not be taken as a guarantee of investment performance
Equities: Another term for shares 
Financial Conduct Authority (FCA): The body which regulates the financial services industry in the UK. Its website can be found at www.fca.org.uk

Index tracker or passive fund: A fund that trackers a particular stock market indices such as the FTSE 100 or S&P 500

NISA: New ISA. Introduced in July 2014, these are ISAs with greater flexibility and a larger annual allowance. Old ISA pots can be transferred into NISAs

Open Ended Investment Company (OEIC): A form of fund that can be held within an ISA. Unit trusts are a type of OEIC

Personal Equity Plan (PEP): A form of tax incentive for investment that existed before ISAs. Although it is not possible to take out new PEPs it is possible to transfer old allowances into ISAs

Stocks: Often used as an alternative term for shares or equities

See Morningstar's online Glossary to learn more about investment terms.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author Emma Wall

Emma Wall  is Senior Editor for Morningstar.co.uk