ISA, SIPP or ordinary dealing account? Each method of buying shares has its pros and cons.
Spend any time on the Fool's investment discussion boards, and you'll quickly spot that people buy shares within three very different account 'wrappers'.
Some use one or more variations of the classic brokerage account -- buying on-line through a low-cost execution-only broker, for instance, or placing an order to buy or sell over the phone. Some, though, buy within an ISA account, managed by a bank, broker or other financial institution. And finally, some buy within a SIPP.
Visit a popular discussion board such as the Fool's High Yield Portfolio board, and you'll soon see people doing all three. Even more confusingly, sometimes it's the same people doing all three!
So what are the benefits and drawbacks of these various accounts -- and why would you want to buy shares within a SIPP or ISA, rather than through a traditional brokerage account or its more modern 'execution-only' equivalent?
ISAs
Buying shares within an ISA is something of a no-brainer. Even the most hardened cash ISA investor has a tax-free ISA allowance that can only be used for investing in equities, and it's plain commonsense to make use of it.
Buy shares within an ISA, and capital gains and dividends are free of tax. The rules about capital gains tax are complex, and have recently changed, but parking your shares within an ISA neatly sidesteps the whole problem.
Dividends used to be free of all income tax (even that tax levied 'at source') but alas, this useful exemption no longer applies. Even so, if you're a higher-rate taxpayer, dividends received on shares held in an ISA attract no further tax.
There's the attraction of simplicity, too. If you're building up a juicy portfolio of dividend-paying shares to live off in retirement, then income earned from an ISA doesn't even have to be declared on your annual tax return.
The downside? First, you can't just buy any share within an ISA. Under government rules, they have to be on "recognised stock exchanges" -- and the AIM exchange isn't one of them. However, an AIM share can be bought, provided that it's also listed on a recognised exchange, which may be foreign.
The second downside concerns investment limits. Until the most recent budget, the Chancellor permitted us to only sock away £7,200 in an equity ISA each year. (Or £3,600 for those making full use of the cash ISA allowance.)
The most recent budget, thankfully, proposed raising this in the present 2009/2010 tax year to £10,200 (or £5,100 for those making full use of the newly-raised cash ISA limit) for people over 50. And from April 6th 2010, the intention is that the new £10,200 allowance will apply to all investors, irrespective of age.
Parliament has yet to vote on the proposal, but it looks pretty safe. Even so, you won't be able to stash away more than £10,200 each year until (and if) the limit is raised again.
SIPPs
Self Invested Personal Pensions (SIPPs) are another handy way of taking advantage of a favourable tax regime while buying and selling shares. Unlike an ISA, the relief is only on the way in, rather than on the way out. Payments going into a SIPP attract basic rate tax relief, effectively adding to your investment.
Simply put, to buy a £1,000 of shares in a SIPP, you'd buy £800 worth, and the taxman would chip in £200. Better still, if you're a higher rate taxpayer, you'd then claim another £200 in tax relief through your annual tax return, meaning that your £1,000 of shares had only cost you £600. That's quite a bargain, and goes a long way to explain the popularity of SIPPs.
Even better, share sales within a SIPP don't attract capital gains tax -- and if you choose to take 25% of the SIPP as a cash lump sum on retirement, that's tax free as well.
However, as with an ISA, there are downsides. First, there's that word "retirement". A SIPP is a pension fund, and you can't get your hands on your money until you reach the designated retirement age. Only then can you go into drawdown, or convert the SIPP to an annuity.
Second -- and unlike an ISA -- income from a SIPP is taxable, apart from that first 25% (if you take it). So if you build up a decent-sized pot solely in a SIPP, you can expect to pay a decent-sized amount of tax on your income from it.
Brokerage account
Brokerage accounts have none of the restrictions and downsides that apply to ISAs and SIPPs. An AIM-listed share? Certainly, sir. You'd like to sell some shares and buy a yacht? Of course, madam. And you'd like to invest over £10,200? No problem.
But having seen the advantages of ISAs and SIPPs, you can guess at some of the disadvantages of brokerage accounts.
Capital gains tax, for instance, where applicable. No handy tax relief on the way in, either, effectively boosting the value of your investment for nothing. And higher-rate income tax is payable on earned dividends, too, if you're a higher-rate taxpayer.
So what's best?
Here's the good news: very arguably, all three ways of buying shares have their place. It certainly makes sense to make sure that your first investments each year make full use of your annual ISA allowance. To do otherwise is to simply throw money at the taxman.
Yes, you're not getting that tax relief on the way in -- but you're getting it back on the way out, and you've ready access to your capital in the meantime.
Once the ISA allowance has been exhausted, it certainly makes sense to seriously think about the attractions of a SIPP -- especially if you're a higher-rate taxpayer now, but likely to be a lower-rate taxpayer in retirement. The downside: no ready access to your capital in the meantime.
And if SIPPs don't appeal, there's the brokerage account, or a combination of a brokerage account and an ISA operated in tandem. A long-term investment in a company paying decent dividends? Park it in the ISA. A short-term punt on an AIM-listed gold miner? That'll be the brokerage account.
In short, with all three options freely available in low-cost formats, maximising the returns from your investments has never been easier.
> The Motley Fool Share Dealing service offers ISAs, SIPPs or plain vanilla brokerage accounts. You can even have all three!
