It seems hard to credit, but individual savings accounts (ISAs) are fast approaching their ninth anniversary. Introduced in April 1999 as a New Labour alternative to the previous administration’s personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs), ISAs have had an uneven development, caught between
the Government’s opposing desires of encouraging private investors to save more and, at the same time, limiting the amount of tax revenue they give up in the process.
This is why so many private investors (over 17 million at the last count) have taken out ISAs. As far as the ISA investor is concerned, they are tax free. There is no liability to income tax or capital gains tax (CGT) on the proceeds of ISA investments. You don’t even have to mention them on your tax form.

Permanent advantages
Malcolm Cuthbert, head of financial planning at stockbroker Killik & Co, suggests that ‘By default, ISAs have now become a tax break for life as the Government has committed itself to them indefinitely. ISAs have been one of the most successful saving vehicles ever. They could have been even more successful had Gordon Brown not announced in 1999 that they had a limited shelf life of ten years. In our view, this uncertainty has held clients back from maximising their contributions to ISAs.’

This was one of a series of changes to the ISA regime announced prior to the 2007 Budget, but due to come into force from 6 April 2008, which will generally have the effect of making the ISA regime more flexible and more attractive to investors.

So what is the ISA scheme all about? The first point to make is that an ISA is not an investment, it is a wrapper into which investments can be put. It is individual in the sense that it is for private investors – there is no such thing as an ‘institutional ISA’ – who can invest, up to certain set limits, into one ISA each financial year. At the end of this period, their existing ISA can no longer receive new investments, but another ISA can be taken out for the new tax year.

The PEP scheme ran along similar lines, although it took time to evolve. Like ISAs, PEPs could only be taken out by individual investors, were limited to one a year, were subject to annual investment limits, could not receive further investment in the next financial year and were free of income tax and CGT liabilities.

Although ISAs replaced PEPs in 1999, existing PEP schemes could still be managed and retained their tax advantages. However, when the new ISA regime comes into force on 6 April, PEPs will effectively cease to exist. They will, instead, be automatically converted to ISAs and form part of an individual’s ISA portfolio. A similar process will convert the TESSA-only ISAs into which maturing TESSAs were put, into the standard-ISA portfolios.

Broader coverage
The rules governing what you can put into these tax-efficient vehicles have widened considerably over the two decades since PEPs first appeared, so that most investment funds, as well as direct holdings and shares, bonds and cash, are now eligible.
Currently, there is a distinction between cash ISAs, which can only hold cash deposits, and ‘stocks and shares’ ISAs. The name is something of a misnomer as these ISAs can accept investments, either directly or via investment funds, in a range of assets, including gilts and other bonds.

However, the new ISA rules are not universally good news for investors who want maximum flexibility in asset allocation. As Malcolm Cuthbert points out, ‘All existing PEP accounts will automatically become stocks and shares ISAs. Another major change is that it will now be possible to move cash from ISAs into stocks and shares ISAs. Unfortunately, the Treasury has decided that it should only be one-way traffic for reasons best known to itself.’

He adds, ‘Nonetheless this has to be a good thing because it enables individuals to rebalance their portfolios and, at a time when interest rates might be on a downwards trajectory, it could be worthwhile moving money from a cash ISA to high-yielding bonds in a stocks and shares ISA.’

How much can you invest?
What about the limits on investment? Until 5 April this year, the old rules for ISAs will apply. You are allowed to invest up to £7,000 tax free and you can choose between a maxi or mini ISA. After 6 April 2008, the distinction between mini and maxi will disappear, but investors will be able to invest £7,200 tax free into an ISA. Up to £3,600 can be in a cash ISA, but the whole amount can be put into other investments under the stocks and shares element if you wish. Investors will also be able to take out cash ISAs from the age of 16 – the minimum age for a stocks and shares ISA remains 18.

Jason Britton, co-fund manager at T. Bailey, explains that ‘Mini ISAs are suitable for people who want the flexibility of getting the best deposit account rate for cash while permitting the stocks and shares element to be invested with a different company that specialises in equities. However, mini ISAs limit the amount that can be invested in stocks and shares to £4,000, so people who want to shelter as much of their equity investment from the taxman as possible should opt for a maxi ISA, where they can invest all £7,000 in equities.’

Another benefit of the broader approach to ISAs is that it will make it easier for investors to consolidate their succession of annual ISAs and PEPs into a single portfolio run
by one manager. Malcolm Cuthbert explains, ‘We think this will lead to a significant increase in the numbers transferring PEPs and ISAs to a new or existing provider. This is a great opportunity to review old and perhaps redundant PEPs. For the first time, it will be possible to view all your PEP and ISA investments on one statement and devise an investment strategy for them.’

He adds, ‘A lot of people pick ISAs from all over the place and don’t necessarily look to see how they have performed. So they may have an Investec ISA one year, a Jupiter ISA the next and a Fidelity ISA the year after and so on, but it is very important to monitor how they are performing. The consolidation process will be much easier in future.’

Britton points out that ‘Nobody can be certain what future governments will do to the savings rules, but the current Labour Government has committed itself to making ISAs a permanent feature of the savings landscape. Previously, it had only confirmed that the tax breaks that come with ISAs would remain until 2010, but it has now made it clear that it sees ISAs as the primary incentive to encourage medium-term saving.’

He adds, ‘Whether the Government will now increase the allowance each year in line with inflation remains a matter of speculation. But it is clear that ISAs are here to stay as the first port of call for anybody investing in the stock market or putting cash on deposit.’