A contractor's comprehensive guide to ISAs
If you are thinking about putting some of your contract rate away for a rainy day then an Individual Savings Account (ISA) could offer a tax-efficient environment for your nest egg to grow, writes ContractorUK Money Club's Tony Harris.
But with new changes to the rules governing ISAs, it is potentially now even more difficult to see the wood from the trees when looking at the huge variety of investment options on offer, so this guide is designed to help you decide if an ISA offers the best home for your savings. This guide should also help to demystify some of the terms that are bandied about the ISA marketplace.
What is an ISA?
An ISA or Individual Savings Account offers a tax-efficient way for contractors to save, as you won’t pay any tax on the interest earned on cash or pay away to the Exchequer any gains made if you choose a more growth-orientated investment.
There are two main types of ISA; a Cash ISA and a Stocks and Shares ISA - and contractors can choose to invest in either or alternatively split their allowance across the two. This is likely to be determined by your attitude to risk as cash ISAs traditionally offer a safer environment for your investment, but has less scope for capital growth than a stocks and shares ISA, which may be exposed to volatility in the markets.
What is a Cash ISA?
A Cash ISA often offers instant access to your funds which makes it useful for short term savings or if you are building an emergency fund which would cover you for a period between contracts, for example. However, this instant access means that providers will often keep their rates relatively low because there is no guarantee that you will keep your funds invested over a medium to long-term period.
If a low risk Cash ISA appeals but you are willing to leave your funds in the account for longer, then you may wish to consider a notice account or perhaps a fixed-rate Cash ISA which will pay an agreed interest rate for a set period, but without access to your savings until the term has ended. The term varies from three months to two years or more and the longer it is; the higher the interest rate is likely to be.
What is a stock and shares ISA?
A stocks and shares ISA offers contractors the opportunity to invest in a wide range of assets in a tax-efficient environment. There are two main types of stocks and shares ISA; a Self-Select ISA which allows you to choose where your funds are invested, or a Managed ISA which is invested and managed on your behalf by a team of investment professionals.
Stocks and shares ISAs often offer far higher potential returns than a Cash ISA because returns are not limited solely by your chosen provider’s interest rate. Instead, you benefit from the growth on any of the assets that you have invested in. These assets can include individual shares, pooled equity investments such as OEICS and Investment trusts, commercial property funds as well as fixed interest gilts and bonds.
From this Autumn, contractors will be able to invest in small and medium-sized enterprise markets for the first time using an ISA, which will allow investors to access over 1,000 companies listed on the Alternative Investment Market. This will not only boost the potential investment opportunities associated with a stocks and shares ISA but will also potentially benefit the business community, as it will offer them an alternative source of finance.
This is an exciting development for contractors because you will be able to access these smaller enterprises that can offer enormous potential for growth within the tax efficient wrapper of your stocks and shares ISA. Not only are individual shares available via AIM but investors can also access pooled investments specialising in smaller companies too. There may also be significant inheritance tax savings available on AIM investment for contractors that are willing to hold on to their shares long-term and some even offer Business Property Relief after two years.
It is important to consider the higher risk involved in an equity-based ISA however, as the value of your investment can go down as well as up - and there is a chance that you won’t get back what you put in. For this reason, contractors tend to favour stocks and shares ISAs for medium to long-term savings, as this should help to minimise your exposure to short term volatility in the markets.
How much can I invest?
There is an annual ISA allowance which is set by HM Revenue & Customs. The annual allowance for 2013/14 is currently £11,520 and contractors can invest up to £5,760 of this in a Cash ISA. This allowance applies to individuals, so if you are married or co-habiting you can each hold your own ISA and each will be able to invest up to the £11,520 limit each year. The annual limit typically increases each tax year.
Contractors should aim to use up the annual allowance each year before saving in alternative high street savings accounts, as you won’t benefit from the tax breaks on interest and growth in other accounts. For many contractors, this annual limit will be high enough to ensure that all of their savings can be kept in the tax-efficient environment of their ISA, and if you use your annual allowance every year then you will soon have built up a significant savings pot which could be used alongside your pension to supplement your income in retirement for instance.
Since late 2011, contractors have been able to save towards their children’s future using a tax-efficient ISA that is entirely separate from your own annual allowance. You can currently invest up to £3,720 per tax year and have the option to open either a Cash Junior ISA or a Stocks and Shares Junior ISA and as with your own allowance, you can also choose to split the investment across both asset classes.
Junior ISAs can be funded by parents, grandparents or carers but any money held in the account will be owned by the child and can’t be taken out until they reach their 18th birthday. Your children would benefit from the same tax-free growth on their ISA that you have on your standard ISA so over time, you could save an impressive sum towards their future. Once they are 18 your child will be able to use the funds to, say, pay their way through university or put down a deposit on a house, so saving a relatively small amount each year now could make a significant difference to your children’s lives.
In our experience, contractors tend to favour Stocks and Shares Junior ISAs because of the long-term nature of the investment, especially if their children are young when they open the account. If you have another 15 years before your child will have access to the account for example, the potential growth offered by stocks and shares will often exceed the potential interest that you would earn on a cash investment in that time. You may also feel that you can take more risk with the Junior ISA than with your own because you won’t be tempted to withdraw the funds and are therefore likely to be able to ride out any short-term volatility in the market. You could always transfer the Junior ISA to a less risky fund selection or even to a Cash ISA as your child gets nearer to their 18th birthday, allowing you to rest assured the growth you have built up over the life of the investment won’t be compromised at the last-minute.
The tax efficient environment of a Junior ISA offers the ideal solution to contractors wishing to save for their children’s future because the growth on your investment won’t be subjected to the tax deductions associated with other savings accounts when your child chooses to withdraw their funds. For this reason, many parents have chosen to transfer their existing savings to a Junior ISA so that they can continue to grow, tax-free.
How do I find the best cash ISA rates?
The ISA market has become very crowded in recent years as more banks and building societies compete for your savings, so it can be difficult to sort the wheat from the chaff and secure the best ISA to suit your individual needs.
The rates available to you will depend largely on the type of ISA that you choose. For example, a fixed-rate ISA may offer better rates than an instant access account, as stated earlier. It would be beneficial to look at all of the options available before committing to your chosen provider, as you are only allowed to have one Cash ISA and one Stocks and Shares ISA per tax year.
An Independent Financial Adviser (IFA) can help you identify the best ISA to suit your savings goals as they will search the whole of the market to find the closest match to your specified needs. Alternatively, there are a number of price comparison sites online, but it is important to remember that these may only show the headline rate and won’t be tailored to your individual requirements.
Look out for the small print
In order to benefit from the tax breaks associated with ISA investment you will need to be a resident in the UK and must be over the ages of 16 to hold a cash ISA, and 18 to hold a stocks and shares ISA. You can only have one Cash ISA and one Stocks and Shares ISA each tax year but can transfer your ISA to a better rate if you need to by going through the transfer process explained in the ‘Switching your ISA to a better rate’ section, below.
When you are looking for a Cash ISA it is important that you read the small print to ensure that you won’t be tied in to a fixed-term that you haven’t chosen, as some providers will stipulate that you must give a certain amount of notice in order to withdraw your funds i.e. one year’s notice. This would be a nasty shock if you tried to access your savings and didn’t realise that a notice period applied, so make sure you know the facts from the outset.
If you have opted for a Managed Stocks and Shares ISA then you will need to check how the fund is invested and what the asset split will be. If you have arranged your ISA through an IFA, then they should have carried out an assessment with you to understand your attitude to investment risk and time horizons. They will then help you choose your investment based on your profile to help ensure that your savings are managed in a way that you feel comfortable with. Check the past performance of the management team that will be responsible for your ISA to ensure that they have a history of achieving good growth to their portfolios.
Switching your ISA to a better rate
Contractors are only allowed to have one Cash ISA and one Stocks and Shares ISA per tax year so if you already have an ISA and have spotted a better deal somewhere else, you will need to go through the ISA transfer process which will safeguard your tax-free allowance.
You will need to have opened your new ISA in advance of transferring the funds so that you can fill in the correct account details on your ISA transfer forms. It can take up to 15 working days to process some Cash ISA transfers, so allow plenty of time to complete the process. Check before you start the switch that your new ISA will allow transfers in as some providers don’t. You can transfer Cash ISAs in to another Cash ISA or in to a Stocks and Shares ISA, but you won’t be able to transfer Stocks and Shares ISAs in to a cash account.
If you are applying for your new ISA through an IFA, then they will often complete the transfer process for you, so you simply need to supply them with the details of your current ISA.
How to get the most out of an ISA
If you have a Cash ISA then try to keep on top of the rates being offered as it may be beneficial to switch to a new provider if a better offer becomes available. The key to success with your ISA is to review the rates regularly to ensure it’s working hard for you. Don’t just leave it in a forgotten account to gather dust as you surely want to maximise the opportunity for tax-free growth on your investment.
If you have a Stocks and Shares ISA then diversification will be key to your success, as you will benefit from having a wide spread of asset classes in your portfolio. This will not only help to make the most of potential growth but will also help to minimise risk as you will have a relatively small sum invested in each area. If you can drip-feed your contributions over the tax year then this will also help to lessen the impact that volatility in the markets may have on your ISA, as you will only ever be investing a small percentage of your overall fund each time. Try to find the time to regularly review your ISA and ensure that your asset allocation is still in tune with your attitude to risk.
But also, try to leave your Cash or Stocks and Shares ISA to grow over a medium to long-term so that you get the benefit of the tax-free growth earned over a significant period. Contractors often choose to have a non-ISA instant access savings account that holds enough money to see them through a break in contracts of, say, three months or to cover unexpected costs, such as car breakdown. They then keep their ISA as a separate long-term savings account which they continue to add to but only access for specific events. If you can afford to run your ISA in this way then you will reap the rewards further down the line when you eventually decide to withdraw the funds as your tax savings could be very significant indeed. In fact, the first ISA millionaires are already beginning to surface - hard evidence of the longer term benefits of shielding your annual savings effort from the taxman.