Catherine Neilan explains how using ISAs for regular savings can build a sizeable portfolio

ISAs are seen as an obvious starting point for anyone looking to build up their savings pot. After all, it can be argued that failure to use the full annual allowance is giving money back to the taxman.

But while individual savings accounts are by far the most attractive savings vehicle available to most investors, a relatively small number of us actually use the full amount, which currently stands at £7,200 through a stocks and shares ISA and £3,600 for a cash ISA each year.

There is no official statistic from HMRC for just what proportion of us hit the limit on an annual basis, but the Tax Incentivised Savings Association (TISA) offers an ‘industry estimate’ of around 15 per cent for those investing in the market, and a more encouraging 40 per cent for the lower-limit cash savers.

In light of the current investment climate – 2008 marked the worst year on record for stock market declines, and 2009 has opened with the Bank of England cutting the base rate to a historically low 1.5 per cent – so should customers consider upping their allocations?

Growing importance
According to Peter Hicks, head of the IFA Channel for Fidelity, the tax shelter provided by an ISA is more important now than ever. He argues that ‘Given the level of government borrowing that has gone on, there is no guarantee tax won’t go up. It is a good idea to use whatever tax breaks you can.This year, I would be looking at any other investments I had outside the tax wrapper – any OEICs or unit trusts for example – and putting them in the ISA.’

Danny Cox, head of financial advice at Bristol IFA Hargreaves Lansdown, agrees that the prospect of rising taxes makes it imperative that ISAs are used. He cites a recent study that claims four in ten families are now not paying taxes because they do not earn enough, or are not earning at all.

‘The reverse of that is that six out of ten families are paying to make up for those four. That, and the amount of debt the country as a whole is in, means there is a huge need to create revenue through tax. One of the ways the individual investor can avoid this is to make use of their ISA allowance.’

Cox says investing via an ISA is ‘top of the shopping list’ because of the benefits it affords those in both higher rate and basic rate tax brackets – no capital gains tax, no income tax and only ten per cent paid as a tax credit on dividends. ‘It is one of the most tax-efficient ways you can save,’ he says.

Building up over time
Cox points to an investor utilising what was the maximum allowance of £7,000 at the beginning of 2003, 2004 and 2005 outside the ISA vehicle. Had the money gone into an ‘averageperforming’ UK All Companies fund – the largest and most popular sector in the Investment Management Association’s universe – the investor would now be in breach of his or her annual capital gains allowance, which currently stands at £9,600 – and would be faced with a bill on taking the profits.

In the current market, investors’ minds may be far from worrying about any gains, but both Hicks and Cox warn against becoming complacent just because there has been a bad few months.

‘It is just as, if not more, important to use your ISA allowance, because – you would hope – there will come a time when the markets come back, and if you are in an ISA those gains are completely tax free,’ says Cox.

‘People say they don’t gain enough to pay CGT, but if they use their allowance fully every year, it is easily accumulated,’ Hicks adds. ‘Their memories will go back to the past months, when the stock market has not been so kind, but if you go back just to 2003, and had invested year after year, it would easily build up.’

As a result of the market falls – which left the FTSE 100 hovering around 4,450 points at the start of the year – Hicks argues that now is a good time to enter the equity market. Investment Management Association’s universe – the investor would now be in breach of his or her annual capital gains allowance, which currently stands at £9,600 – and would be faced with a bill on taking the profits.

In the current market, investors’ minds may be far from worrying about any gains, but both Hicks and Cox warn against becoming complacent just because there has been a bad few months.

‘It is just as, if not more, important to use your ISA allowance, because – you would hope – there will come a time when the Although he advocates pound cost averaging (see box) as offering investors ‘peace of mind’ as well as building a regular discipline of saving, he admits that investing at, or near, the bottom, ‘is, of course, better’.

Boosting your income
As well as the perennial avoidance of tax, the coming year could present new challenges for people who have in the past only invested in cash, if the Bank of England continues its dovish stance by keeping interest rates low in a bid to stimulate growth.

Hargreaves Lansdown’s Cox is among several commentators to have forecast that rates will fall as low as one per cent, despite their already being lower than ever before. This, in turn, means that those savers on a fixed-rate deal maturing in 2009 could lose a significant proportion of their income.

This IFA is recommending that cash investors consider turning to fixed-interest funds, which can invest in higher-yielding corporate bonds, to replace this source of stable income.

‘It is riskier than a savings account, but it is one way of generating income and, of course, is tax free in an ISA. For investment-grade bonds, given where we are in the market, I would hope there would be some capital return as well,’ he says.

‘It is one of those things people should be doing anyway, but if they have taken their eye off the ball, or have been worried about the markets, they definitely need to be considering using their ISA allowance.’

Again, Hicks agrees: ‘You go back a year, and you were seeing bus stops with adverts promoting eight per cent returns from savings accounts. Of course, you won’t get that now.’

The case for cash
But despite the downbeat predictions for savers, those who still feel uneasy entering the market could find that cash ISA accounts still have an advantage over normal savings accounts, according to Tony Vine-Lott, director general of TISA.

Although banks are largely lowering their savings rates to coincide with the Bank of England’s rate cuts, ISA accounts tend to retain a slightly higher level. ‘Banks tend to assume an ISA saver will be with them for longer than a non-ISA customer, so the money is more attractive to them and you get a higher rate,’ he says.

But Vine-Lott also advocates, for the right type of investor, ‘dripping’money into the stock market regularly, irrespective of the timing, to make the most of pound cost averaging. ‘People tend to invest when the market is high, whereas the best time is when the market is low,’ he says.

Vine-Lott explains that ‘This is why they should make regular investments – monthly, quarterly or annually. There is lots of research to show that this is the best way to build up capital. If you are consistent in what you invest over time, you can maximise your returns.’

However, despite this emphasis on regular saving, Vine-Lott agrees that falling savings rates and rising dividends with the market declines make the present ‘a relatively good time’ to invest.

But do investors agree? ISAs out of favour At least until the start of this tax year, the number of people investing in an ISA – into either a cash or shares vehicle – has grown steadily since 2003/04, when there was a fall in the number of people making use of the vehicle, apparently as a result of the bear market, which hit its low point in March 2003.

The tax year ending April 2008 saw roughly 1.58 million people subscribe to a maxi ISA, with the average subscription around £4,800. Meanwhile, 13.1 million people took out a cash or shares mini ISA, with investments averaging £1,750 to £2,200 depending on the type of asset. Both the number of investors and the amount of subscriptions increased on the previous tax year.

However, the most recent statistics from the IMA, for the month of November 2008, show net outflows from unit trust ISAs to the tune of £25 million.

During the third quarter of 2008, ISA investors pulled £992.7 million of their cash out of the market, while the previous quarter saw net inflows of just £31m trickle into the investment vehicle.

Total funds under management have fallen from £462.6 billion in November 2007 to £338 billion a year later – a drop of 27 per cent. This is no doubt largely as a result of the falls in the equity markets – the FTSE 100 ended more than 31 per cent down at the year-end while the Global MSCI index was down 43.7 per cent – but clearly investor appetite is far from healthy.

However, Fidelity’s Hicks says he is ‘optimistic’ that ISAs will see a sudden cash boost. ‘Interest rates are now so low, and probably likely to drop again, people are getting half the savings rate they were getting even six months ago,’ he says. ‘So investors will see that, particularly those relying on income, and see that dividends on companies like BP and Tesco are four to five per cent. That will make people more likely to consider investing in the market.’

He adds, ‘In terms of new money coming into ISAs, there is usually a bulge in the last three weeks of the tax year – my guess is that this will happen in the last week of this year.’