Should I Get A Cash Or Shares ISA?

With uncertainty all over the financial pages, find out whether you should be saving in cash ISAs, instead of investing in shares ISAs.

You may have seen cagey, uncertain, or even panicked comments in the money pages over the past few months, and you're wondering whether your money would be safe in the stock market, or whether you should have all your money in safe savings accounts.

Put another way, should you save in a cash ISA or invest in a shares ISA?

Firstly, we'll look at the basics: what is an ISA, and what's the difference between cash and shares ISAs? Secondly, which type of ISA is most suitable right now.

All ISAs (individual savings accounts) shelter your savings or investments from tax:

Cash ISAs

Each year, from 6 April to 5 April the following year, you can put £3,000 into a cash ISA. (This amount is due to go up to £3,600 from 6 April 2008.) You're paid interest on this, just like normal savings accounts, only no tax is deducted.

At present, the best catch free, normal  savings accounts pay around 6.2%, which is just under 5% per year after tax for basic-rate taxpayers, and around 3.7% for higher-rate payers.

However, you can get decent cash ISAs paying around 6%, which means that, on £3,000 of savings, you could earn £180 per year. To put it another way, basic-rate taxpayers could earn £30 more than they would in a normal savings account, and higher-rate payers could earn £60 more.

Shares ISAs

With shares ISAs you can invest up to £7,000 in the stock market each year (which is going up to £7,200 from next April), and whatever gains you make when you sell are tax free. Within shares ISAs you can buy individual shares or invest in funds.

Normally, when you sell shares for a profit of more than £9,200, you pay 40% tax on the excess. So if you bought shares five years ago and sell them for a profit today of £10,200, you get back £9,200, plus £1,000 minus 40%, which is £600. Higher-rate taxpayers also pay income tax on dividend payments. (Dividends are bonuses that many companies pay to shareholders each year.)

However, these taxes are legitimately avoided when you buy your shares through an ISA.

Should I get a cash or shares ISA?

So which is better right now, cash or shares ISAs? The choppy stock markets are making people nervous, and the higher interest rates that we're seeing these days make savings more attractive. So naturally you'd expect me to advise that you should put more money into cash.

But no! The Foolish philosophy is nice and simple. It all depends on one simple question:

• How long can you save or invest for?

As a general rule, if you think you might need the money within five years, it's best to keep it in cash. That's because over the short-term we have no idea where share prices might go. So that's all nice and straight forward.

If you won't need it for five years or even longer, then shares are a good option. In fact, the longer you can leave it stashed away, the more attractive investing in shares is. You have greater safety from volatile share prices and you're more likely to make good returns that far outstrip cash, although, of course, there are some risks. For more information on the risks and rewards of cash versus shares over different periods of time, see How, When And Where To Invest.

If you decide you want to invest in shares ISAs, you can still hedge against fluctuating shares prices by investing in tranches: instead of throwing all your money into the ISA at once, what you do is you divide it equally over, say, 6 to 12 months.

The best ISAs at present

For a long time my favourite cash ISA has been the National Savings and Investments Direct ISA, but no longer, because it hasn't extended its excellent interest-rate guarantee, which is now only six months (down from more than 18 months).

I now consider Bradford & Bingley's easy access eISA 2 to be the best cash ISA. It pays 6.05%, it's catch-free and it's guaranteed to at least match the Base Rate till the end of June 2009. You can also transfer existing cash ISAs into it, if you want to consolidate all your tax-free savings.

The only rub is that you must keep at least £1,000 in the account or your interest rate drops to virtually nothing. If that's inconvenient, the Egg Cash ISA is the next best that I can see, with an interest rate of 6.05%, a £1 minimum deposit, no catches, and a guarantee to at least match the Base Rate till the start of April 2009. The downside is that you can't transfer existing ISA funds into it.

As for shares ISA, we always recommend that you invest in the cheapest index tracker that you can find. We wrote about The Top Ten Trackers in a recent article.

> Read our comprehensive guide on ISAs.
> If you've already used up your cash ISA allowance, get the best savings account you can with the remainder of your savings.
> Cash Or Shares ISAs