ISAs

Tax−efficient wrappers − a quick guide

An Individual Savings Account (ISA) is a tax−efficient wrapper in which investments such as cash, shares and stock market funds can be held to avoid capital gains tax and to reduce income tax.

There are two types of ISA – a mini and a maxi, although this will change for the next tax year.

For the 2007/8 tax year a maxi ISA has a limit of £7,000 for any one tax−year and in it you must hold shares or funds, although you can add other investments such as cash. Alternatively, you can open two mini ISAs − a cash mini ISA, which has a £3,000 limit, and a stocks and shares mini ISA, which has a limit of £4,000. Importantly, you cannot take out a mini ISA and a maxi ISA in the same tax year.

The interest you earn from a cash mini ISA is free of income tax, while you do not pay any capital gains tax on stocks and shares ISAs.

All change from the 2008/9 tax year

There will be no maxi or mini ISA.

The annual ISA investment allowance will be raised to £7,200 (up to £3,600 of that allowance can be saved in cash with one provider).

The remainder of the £7,200 can be invested in stocks and shares with either the same or a different provider.

ISA savers will be able to invest in two separate ISAs each tax year (a cash ISA and a stocks and shares ISA).

Mini cash ISAs, TESSA only ISAs (TOISAs) and the cash component of a maxi ISA will automatically become cash ISAs.

ISA savers will be able to transfer money saved in their cash ISA to their stocks and shares ISA.

Up until 1999, PEP investors were able to reclaim a 20 per cent tax credit on dividends. When ISAs replaced PEPs, the Government cut this concession to 10 per cent and in 2004 the concession was scrapped altogether.

Although the dividend tax credit has disappeared for equity ISAs, higher rate taxpayers can still benefit from income tax savings. Higher rate taxpayers have a tax liability and, under current rules, pay tax of 32.5 per cent on any gross dividend paid. This cuts each net dividend of £100 to just £75. However, for dividends within an ISA higher rate taxpayers are treated as basic rate taxpayers and get a net dividend payment of £100 − £25 more than they would if their investments were held outside an ISA wrapper.

The scrapping of the dividend tax credit does not affect corporate bond ISAs. Income generated by gilts and corporate bonds is not classified as a dividend and is not subject to the same tax restrictions. This means people holding a corporate bond ISA will still benefit from the full 20 per cent tax credit.

Levels and bases of, and reliefs from, taxation are subject to change.