ISAs are useful tax-saving wrappers. Using them to their best involves some surprisingly difficult decisions.
We hope you are clear that an ISA is a wrapper, not an investment.You cannot "invest in an ISA", no matter what the advertisements say. You can only invest in X, Y or Z. Then, you can chose to hold X,Y or Z in an ISA. Financial service providers like to blur this distinction so that they can sell you the whole package. And once they've got you they can rely on you not to pay too much attention when they raise the charges, or when the in-house funds they have put you into fail to perform.
Some ISAs charge up to 5% initial fee and 1.5% per annum thereafter. This will kill your returns (compounding). And don't think you will get any special management expertise. These fees will be spent on sales commissions and marketing expenses. Any hot investment manager (if there is such a thing) will be assigned to high profile specialist funds. Not to general funds aimed at the inexperienced public.
The facts (2019)
Each individual can place up to £20,000 per year in an ISA, in a wide, but not totally unrestricted, range of assets. All such assets are free of both income and capital gains taxes.
You can take cash out of an ISA but you cannot later put it back again. Further you cannot carry an unused ISA allowance forward from one year to the next. It's 'use it or lose it'. To fail to use an ISA allowance is to turn down a tax free fund for life - particularly damaging when there is lots of life left - i.e. you are young. That is precisely when you are least likely to be able to afford it.This is what makes the personal decision difficult.
Choosing an ISA
The two themes are flexibility and low cost. Your ISA could be for life. Without flexibility you cannot adjust to meet changing circumstances, nor do you have any defence against rising costs. ISAs that satisfy these conditions will almost certainly be simple, not heavily promoted, and without sign-on inducements.
- one that will allow you to hold a good range of investments. ISAs described as "self-select" will do that. There are lots of them.
- low account management charges
- good interest rates on cash balances. Remember you cannot move cash out of the ISA and move it back later. So you are stuck with cash balances from dividends accumulating in the ISA until you have enough to make another investment.
- low dealing charges. These may be higher than for dealing in your usual brokerage account.
- ability to move investments to a brokerage account without sale and repurchase
- no exit fees
It is extraordinarily difficult to give generalised advice on ISAs. We make a number of points below. Every one should be qualified with the words 'probably' and 'depending on your personal circumstances', and it is for you to do the maths that will help you make your own decision:
- It can't be emphasised enough, and we repeat it here, it's 'use it or lose it'. A contribution to an ISA will generate tax-free income for the rest of your life. You may be a low taxpayer now, but will you still be a low taxpayer in 30 years time?
- .....but if you are still poor in 30 years time perhaps you will even more regret the time and money you have wasted on ISAs?
- The worst that can happen to you, if you open an ISA and later want to withdraw the investment, is that you will have wasted an annual administration fee but saved a bit of tax.
- The tax benefits of a SIPP are more than those of an ISA, but you lose control of your capital in a SIPP
- If you have decided not to use an ISA allowance, why don't you at least put some of your cash cushion into it and save income tax on the interest until such time as you need the cash?
- ....but if you put cash in an ISA you can't get at it without losing any future tax benefits. Isn't liquidity the whole point of cash?
- .....and the return on shares should be better than the return on cash. If the equity risk premium is 3% then in 30 years time you will be getting tax relief on a sum that is two and a half times bigger than the cash equivalent.
The government of the day occasionally float specialised ISAs to target some particular voter-sensitive issue. Currently it is young couples attempting to buy their first house. If you or yours are aged 18-40 and potential first-time buyers a 'lifetime ISA' could be just the ticket.