Personal Finance – How to solve the mystery of ISA

Hands up if you know what an Individual Savings Account is all about.

If you do, and you know all the investment rules, congratulations – the chances are you are among a tiny minority of UK savers who do.

For the rest of us, the ISA is one of those financial brainwaves which we promise to get round to understanding one day – but not just yet.

If so, we could be making a mistake. At a time when we are being urged to take increasing responsibility for our own welfare provision, it makes sense to save. The ISA, which replaced the PEP on 6 April, offers the opportunity for savers to do so without having to pay income or capital gains taxes.

In essence, the ISA is a tax wrapper, in which you can place a combination of cash, insurance or equity-linked investments, up to a limit of £7,000 in the current tax year and £5,000 each year thereafter.

Two months after the ISA’s launch, there is much confusion surrounding the rules about opening one. A survey by Fidelity Investments indicates only 22% of adults understand the difference between Mini and Maxi ISAs.

This lack of knowledge has dented sales – at least for those companies whose specialist ISAs invest in stocks and shares. Meanwhile, the banks and building societies have taken advantage of the rules allowing them to market simple cash-based ISAs.

For example, Halifax says more than 500,000 customers opened an ISA within seven weeks of the launch, 140,000 of them from outside the group. Other banks and building societies report a similar response.

Fund managers argue that most of this is not new money. It consists of existing savers who have simply switched their cash out of traditional accounts into ISAs. This is not consistent with the government’s target of spreading the saving habit.

Moreover, confusion over the rules means that a considerable number of ISA savers are making an understandable, yet dangerous, error, according to fund managers. This could seriously limit how much savers can stash away in their ISAs.

For example, you can invest your full £7,000 this year in a Maxi ISA, placing the lot in shares. Fund managers say this makes sense, because equities have outperformed cash over the long term. Or you can divide the money into cash, insurance and shares. If you do, the amount in the Maxi ISA that goes into equities might fall, but only relative to where the rest of the money is being saved. So, if you have £500 in cash and £250 in insurance, the remaining £6,250 can go into equities.

The problem is that you are also allowed to invest in separate Mini ISAs.

There, the limit this year is £3,000 in cash, £1,000 insurance and £3,000 in shares. If you put less into cash or insurance, you are still limited to £3,000 for equities. In other words, you have blown some of the tax-free allowance by going down the Mini ISA route. So far, most new ISAs appear to be Minis.

Anyone tempted to do so should think carefully, says Ann Davis, executive director at Fidelity. ‘Our experience with PEPs shows that the majority of people leave investing in stocks and shares until the last minute,’ she says. ‘It is these individuals in particular who need to think carefully before being tempted by the rates and special incentives offered by banks and building societies.’

Even so, many experts argue that where that groundwork has been done, ISA take-up – whether in shares or cash – has been good. Halifax’ figures bear this out. About 150,000 of its ISA customers are investing in equities, with 1,600 joining each week.

Paul Duffin, general manager for mortgages and savings at the Halifax, argues that cash should not be seen as a mistaken investment.

‘The dash for cash is consistent with the view that the vast majority of people should build up their savings on strong foundations,’ he says. The key to success for ISAs is simplicity and value for money.

Roddy Kohn, a financial adviser at Bristol-based Kohn Cougar, says: ‘The reason many are plumping for cash is as much to do with marketing failure as confusion among savers.

‘At the end of the day though, even those who have opened cash Mini ISAs can still invest thousands this year in equities. The fact that more than one million people so far have gone for ISAs is something to be welcomed, not moaned about.’

Nic Cicutti is personal finance editor at the Independent

Related reading