Introduction of ISAs
ISAs were introduced on 6 April 1999, replacing the earlier Personal Equity Plans (PEPs) and Tax-Exempt Special Savings Accounts (TESSAs), which continued to exist only for money already invested in them and for interplan transfers. ISAs were explicitly designed to appeal to a broader range of the population than these earlier products, which were sometimes claimed to be exclusively for the benefit of the middle classes. However, they have been criticised as confusing. Other channels for tax-privileged savings exist that also pre-date ISAs, notably the National Savings and Investments, which is a state owned bank offering a range of non-ISA tax free accounts (in addition to its own ISAs.)
Types of ISA
Initially there were three types of ISA: Mini ISAs, Maxi ISAs and TESSA-only ISAs or TOISAs. The latter were created to allow the original capital (excluding interest) invested in a TESSA (up to £9,000) to be reinvested in a tax-free form. It was only possible to invest in a TOISA with the capital from a matured TESSA, and new TOISAs could be created only for the complete transfer of funds from another TOISA.
New TESSAs could not be created after 5 April 1999, so the required five-year term of all TESSAs ended by 5 April 2004.
In the March 2007 Budget, the distinction between a Mini and a Maxi ISA was abolished. At this point the limits for the 2008/9 tax year were also increased.[1]
Components
An ISA can contain two components:
1. A cash component: a cash deposit that is similar to any other ordinary savings account, apart from the tax-free status. A TOISA must consist solely of a cash deposit.
2. A stocks and shares component: the money is invested in 'qualifying investments' consisting of any combination of stock market equity investments (with no geographic restriction), public debt securities such as government or corporate bonds, or cash "awaiting investment". As a consequence, the risk profile of the ISA may be anything from low to high. The investments may also include or consist of property funds or derivatives such as options. This element may be self-invested and managed through a stockbroker, but the majority of investors invest collectively through a collective investment such as a unit trust, OEIC or investment trust.
A third component, the insurance component, was also available in both maxi and mini ISAs. However, since the 2005/06 tax year this component has not been available. Collective investment funds that once qualified for this component will have been reclassified as qualifying for either the Cash or Stocks & Shares component. The tax year in the UK is from 6 April to 5 April.
Transfer rules
It is possible to transfer ISAs from one manager to another, however there are several points to be aware of.
* From 2008/2009, it is possible to transfer from a Cash ISA to a Stocks and Shares ISA, but not the other way round. Before 2008/2009, it was not possible to transfer between component types.
* Whether the original contributions were made to a Maxi or Mini has no effect on transfer.
* The transfer must be done between the managers. If a saver transfers the money manually, it will be treated as a withdrawal and they cannot invest this in an ISA if their subscription limit has already been reached.
* Transfer of an ISA from the current tax year must be total. Partial transfers are only allowed on ISAs from previous tax years.
* Cash within a TOISA is treated as a cash component, and can be transferred to a "normal" cash ISA.
Subscription limits
There are restrictions on investing in ISAs in each tax year (6 April to the following 5 April) which affect the type of ISA that may be opened and the amount of the investment.
Any UK resident individual of at least eighteen years of age can invest in one 'maxi' ISA, with both components provided by a single financial institution. Alternatively, a person can invest in two 'mini' ISAs, one for each component (see above). The two mini ISAs may be with two different providers if the investor wishes. TOISAs and the full transfer of ISAs created in previous years to another provider have no bearing on these restrictions. With a few exceptions, such as from an employee share ownership plan, all investor contributions must be in cash.
UK resident individuals aged between 16 and 18 can also open a cash mini ISA or a maxi ISA, but can only allocate their investment to the cash component.
The amounts which may be deposited in an ISA in a tax year are fixed by law. For all years up to and including 2007/8, the limits have been:
* For a mini-ISA:
o Cash: up to £3,000
o Stocks and shares: up to £4,000
* For a maxi-ISA: a total subscription limit of £7,000 which may be invested:
o Cash: up to £3,000
o Stocks and shares: up to £7,000
In the March 2007 Budget, the limits from the 2008/9 tax year were increased. The distinction between a mini and maxi ISA was also abolished resulting in the following simplified limit structure:
* A total subscription limit of £7,200 which may be invested:
o Cash: up to £3,600
o Stocks and shares: up to £7,200
The Chancellor of the Exchequer Alistair Darling announced in the 2009 Budget that the subscription limits would be increased to £10,200, of which £5,100 can be saved in cash. These changes will be effective from 6 October 2009 for those aged 50 and over, and from 6 April 2010 for all others.[2]
Tax treatment
All income (dividends and interest) and all capital gains are tax-free.
Interest on any cash held in the stocks and shares component is subject to a flat charge of 20%.
From 6 April 1999, advance corporation tax (ACT), payable by companies when they paid dividends, was abolished. Previously, under the imputation system of taxation, recipients of a dividend were entitled to a tax credit which reflected the payment of ACT by companies. This tax credit reduced the amount of tax that was payable by the recipient of a dividend and, where the recipient's tax liability was less than the tax credit, the excess could be reclaimed (particularly by non-taxpayers, such as charities, pension funds and PEPs).
From April 1999, companies have not been required to pay ACT, and dividends are accompanied by a 'notional' 10% tax credit. The ability of certain non-taxpayers to claim a repayment of this 'notional' tax credit was phased out from 6 April 1999 to 5 April 2004, effectively removing some of the originally tax-free status (although higher-rate taxpayers have no further liability which they would do on dividends held outside an ISA). The result is that a fund primarily used for income rather than capital growth is far less tax efficient (especially for non higher-rate taxpayers) when placed in an equity fund, whereas a fund based exclusively on other asset classes (such as bonds) continues to be tax-free in terms of income as well as capital growth.
The government has guaranteed that ISAs will continue to have tax-free status in all other respects until 5 April 2010, although they may be continued beyond that date.
CAT standards
In April 1999, the Government introduced a voluntary CAT standard for ISAs (standing for "Charges, Access, and Terms") to make them easier for inexperienced customers to understand and with the proposed intention that lower costs would attract more investors. It does not guarantee the investment performance or that investors would buy or be sold the right type of investment. Many products comply with the CAT standard and there is some controversy as to whether or not the CAT standard alone would reach out to many more people who would not have otherwise chosen to save[citation needed].
Cash ISAs have nevertheless been beneficial to savers through providing instant access savings that require little investment, meaning that the first £3,000 of any cash savings each year will be in a tax-free environment. By way of contrast, only the interest could be withdrawn from a TESSA before its five year period had finished or the tax free status would be lost. Further, due to competition cash ISAs continue (as at September 2004) to offer the highest rates of interest, irrespective of tax status, often meaning £1 in an ISA gains a higher rate of gross interest than many thousands invested in another account with the same provider. The market is further advanced as non-taxpayers still benefit from the use of cash ISAs due to the favourable interest rates.
Many equity funds also meet the CAT standards, but the restriction on costs generally means that these funds are index funds, which require little management and simply follow a given index, such as the FTSE 100 Index.
Charges
The ISA cash component is typically free of charges although some providers charge a fee for transferring to another provider.
The built-in annual "re-registering" of your ISA may attract a fee which may be automatically extracted from your account.
Collective funds in the Stocks and Shares component usually attract the same initial and annual charges as they would do if held outside an ISA.
Self Select Stocks and Shares ISAs, provided by a stockbroker, attract brokerage fees comparable to those outside an ISA. Many stockbrokers charge an additional fee for administration of the ISA.
Fund Supermarkets
Investors are only permitted to invest their Stocks and Shares component with a single financial institution in any year. For investments into collective funds, these institutions have traditionally been the fund management companies themselves. This creates a difficulty for investors wishing to diversify their investment into the collective funds of different fund management companies in the same year. It also means that investors wishing to transfer existing ISA holdings have to transfer the ISA itself between providers, which can be a time consuming process.
To avoid these problems, a number of Fund Supermarkets have been set up. These are organisations which act as ISA providers who offer access to a wider range of collective investments from a variety of fund managers. They allow investors to build a more diversified portfolio within a single ISA and to transfer their investments between funds without the complication and delay of changing ISA provider. Fund Supermarkets are promoted by many Independent Financial Advisers and have quickly become popular because they allow investors greater choice and flexibility at no extra charge. Instead of charging the investor, the Fund Supermarkets are paid by the fund managers out of their usual charges. Examples of large Fund Supermarkets are Fidelity FundsNetwork, Hargreaves Lansdown's Vantage Service and Interactive Investor.
A Fund Supermarket differs significantly from a true Self Select ISA provided by a stockbroker. The Fund Supermarkets do not offer the entire range of ISA eligible collective funds nor do they allow investment directly into specific stocks or shares.
