MARKET COMMENT
ISAs Haven't Lost Their Shine

By Cliff D'Arcy
March 15, 2004

Despite proclaiming its commitment to encouraging the public to save (especially for retirement), the Treasury appears to be doing all it can to undermine this goal by increasing the £27 billion 'savings gap' (PDF file)!

Take, for example, impending changes to Individual Savings Accounts (ISAs), the government's flagship product for savers and investors, which aims to be all things to all people:

• A risk-averse investor can deposit up to £3,000 per tax year into a cash mini-ISA. All interest earned is paid free of tax.
• An investor seeking income can invest up to £7,000 annually into corporate or government bonds sheltered inside a maxi-ISA (or up to £3,000 in a mini-ISA if they have already opened a cash mini-ISA in that tax year).
• Stock-market investors can invest a maximum of £7,000 in a shares maxi-ISA (or up to £3,000 in a shares mini-ISA if they have already opened a cash mini-ISA in that tax year).

Since replacing PEPs and TESSAs in 1999, ISAs have been used by investors to improve their investment returns by avoiding tax on income and profits (capital gains). However, the Treasury has been unable to resist tinkering with ISAs and has announced a number of changes for the worse...

From 6 April 2004 - in less than two months - ISA managers will no longer be able to claim the tax credit on dividends paid by shares held in an ISA. This removes the main incentive for basic-rate taxpayers to hold shares or equity funds inside ISA wrappers. This is because dividends earned within shares ISAs will effectively be taxed at the same rate as dividends from shares held directly by basic-rate taxpayers. The other benefit - avoiding capital gains tax (CGT) - is largely irrelevant, because few basic-rate taxpayers make gains in excess of their annual CGT exemption of £8,200 (for the 2004/05 tax year).

What's more, from 6 April 2006, the government is slashing the investment limits for ISAs. The ceilings will drop to £5,000 for maxi-ISAs and £1,000 for cash mini-ISAs. Read more.

However, shares ISAs are still a no-brainer for higher-rate taxpayers - those with incomes of roughly £35,000-plus - because they still benefit from lower tax bills. Dividend income outside of an ISA attracts an extra 22.5% tax on gross dividends paid, which raises the total tax rate to 32.5%. What's more, higher-rate taxpayers are more likely to make taxable gains, so the freedom from CGT is a useful benefit.

Nevertheless, many fund managers do not charge additional fees to investors who wish to shelter their fund investments inside an ISA. Therefore, if tax-efficient wrappers come at no extra cost, it makes sense to use them.

In addition, investors seeking income may benefit from sheltering bond, rather than equity, investments inside their ISAs. Currently, fixed-interest investors can still reclaim a 20% tax credit on the income they receive within ISAs, which effectively means their income is paid gross. Outside of an ISA, a bond investor paying basic-rate tax would lose a fifth of their income; for higher-rate taxpayers, this jumps to two-fifths. Hence, the attraction of holding bonds inside ISAs is still clear, although it remains to be seen how long this particular tax incentive will last!

Finally, don't forget that another benefit of ISAs is that neither income nor gains have to be declared on your tax return. Anyone who has ever completed an SA100 (a self-assessment Tax Return form) knows just how valuable a concession this is!

More: Visit our ISA centre | What Are You Doing To Our ISAs, Chancellor?.