How to make money tax-free!

Government tax breaks are not-to-be-missed. Find out how to make the most of Britain's favourite tax-free accounts.

ISAs really are very popular with savers. In fact, cash ISAs are the second most popular type of savings account with total deposits of around £158 billion.

Stocks and shares ISAs are also doing pretty well with the end of this year’s ISA season in April seeing the highest sales for nine years.

So, what’s all the fuss about?

Tax!

Quite simply it’s the tax breaks which make them so attractive to savers and investors alike. After all, cash ISAs are no more complex than ordinary savings accounts, except that you lose none of your interest to the taxman.

But the tax treatment of stocks and shares ISAs is more complex because, unlike interest earned in cash ISAs, dividend income received within a share-based ISA isn’t actually completely tax-free.

All UK dividend income is subject to a 10% tax credit, which means a tenth of the dividend will be automatically deducted from your ISA before you even see it - and you won’t be able to reclaim any of this tax back. But that aside, stocks and shares ISAs are free from income tax, and when you finally encash your ISA, it won’t be subject to capital gains tax either even if it has grown significantly in value over the years.

It’s just a wrapper

At the end of the day, an ISA is nothing more than a tax-efficient wrapper around products which already exist. So, it really would be a mistake to miss out by putting your money into taxable products when you really don’t need to.

I would always recommend any saver uses up their cash ISA allowance as their first port of call before opening an ordinary taxable account. But this recommendation comes with one important caveat: cash ISAs aren’t quite as flexible as easy access savings accounts. Under current ISA rules, you can save up to £5,100 into a cash ISA this tax year (which ends on 5 April 2011). If you deposit the full amount, and then make a withdrawal at a later stage, you won’t be able to replace it.

You should bear this in mind when you decide how you will manage your savings. But that doesn’t mean you should skip cash ISAs altogether even if you’re only looking for a temporary home for your savings. That’s because you’ll still be able to benefit from tax-free interest for as long as your money remains held inside an ISA wrapper.

How should you use up your allowance?

The total ISA allowance for the current tax year is £10,200, which the government plans to index-link each year in line with inflation. Of this amount, half - so £5,100 - can be put in a cash ISA, while the remainder can be invested in a stocks and shares ISAs.

Alternatively, you can choose to put the full £10,200 stocks and shares and nothing in cash. You can also vary how you use up your allowance as long as you stick to these rules. So you could, for example, stick £2,000 in a cash ISA and £8,200 in a stocks and shares ISAs if you prefer.

You can even change your mind. If you open a cash ISA, and later decide you want to take more risk with your money, you can move it into stocks and shares. But, don’t forget, money held in shares can’t be switched into a cash ISA.

Should you invest your ISA allowance?

I think you should always choose cash ISAs ahead of ordinary savings accounts. But, right now, the rates available are pretty depressed across all cash savings. If you would like the chance for higher returns in return for taking more risk, consider putting some, or all, of your ISA allowance in stocks and shares.

You could use your ISA to invest in a whole range of assets such as index trackers, exchange traded funds (ETFs), managed funds, investment trusts, bonds, gilts or even directly in shares via a self-select ISA.

It’s a good idea for new investors to try index trackers first of all. An index tracker is designed to replicate the performance of the stock market as closely as possible. So a FTSE 100 index tracker, for example, will invest in all the top 100 UK firms. When the index rises and falls, the value of your ISA investment will move accordingly.

In the last year the FTSE 100 has grown by more than 17%, putting the returns from FTSE 100 index trackers way past those generated by cash ISAs over the same period, even after the fund charges have been deducted.

That said, index tracking ISAs will generally be far more volatile than cash returns. Over a three-year timescale, the FTSE 100 posted returns of -4.5%, which forced growth from index tracking ISAs into negative territory.

But historical returns have shown us that shares generally outperform cash over the long-term. If you don’t like the idea of having an investment which fluctuates in value, you’re probably better off sticking with a cash ISA instead. Or, perhaps you could try your luck on the stock market with a small part of your ISA allowance at first, without taking a gamble on the whole lot.

Taking more risk

For the more adventurous among you, managed funds give you the opportunity to beat the market (unlike index trackers which aim to match it). Managed funds are run by professional fund managers who pick stocks with the aim of maximising the returns for individual investors.

The trouble is managed funds are more expensive than index trackers to cover the fund manager’s expertise. On top of that, managers regularly make the wrong calls and actually end up underperforming the market.

For this reason, these funds involve more investment risk than index trackers, but they offer prospects for superior growth if you select funds run by top fund managers who are capable of generating strong growth over the longer term.

Finally, if you’re a reasonably seasoned investor, you may wish to invest your ISA allowance directly in individual shares which will incur dealing costs. But this is a high risk strategy which could go horribly wrong if the company shares you choose collapse in value. Imagine if your ISA was invested heavily in say, BP shares - you would now be nursing very big losses indeed.

This option isn’t for the faint-hearted. You should always remember to diversify your investment well to spread the risk. And only take this kind of gamble with your ISA allowance if you’re investing money you can afford to live without.

Compare ISAs and index-trackers at lovemoney.com

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