For most taxpayers, holding savings in tax-efficient accounts makes sense. Individual Savings Accounts (ISAs) and previously Personal Equity Plans (PEPs) have been widely used to build up a capital sum, on which individuals can avoid any personal liability to Income Tax and Capital Gains Tax (it is not possible to reclaim tax credits on dividends from UK companies).When PEPs were launched in 1996 you could invest up to £6,000 into a General PEP and up to £3,000 into a Single Company PEP. The original reason for offering the PEP allowance was to encourage investment into UK companies. In 1999, PEPs were abolished and replaced with ISAs, with an annual allowance of only £7,000. If the original £9,000 allowance had kept pace with inflation, it would now be £14,000! What’s more, the new ISAs came with rather complex rules.
This encouragement for saving is all well and good, but over the years, it seemed to me that ISAs were being misunderstood by some people. Some investors were more interested in simply using the ISA allowance itself, rather than thinking about what type of assets they bought, or why, and other investors would not consider ISAs because they perceived them to be risky.
Let’s understand that the ISA, or PEP (or pension for that matter) is just a tax planning vehicle - a wrapper in which assets are held. In other words, the wrapper determines the rules regarding things like tax treatment, charging structure and how accessible your money is. It is the asset inside the wrapper that determines whether the value goes up, down or sideways. Therefore, I feel it is wrong to say that a PEP or an ISA is risky, as it is the underlying assets that determine the nature of the risk.
The financial services industry also has a lot to answer for when it comes to selling PEPs and ISAs. The media constantly refers to an ISA “season”, which frankly I find to be irritating. What they are referring to is the period between about February and 5 April, when people traditionally buy their ISAs at the last minute, to use up the allowance. The ISA season, if there is one, is a tax year.
And then there are the banks! I believe the banks’ primary function is simply to sell us financial products. Take Cash ISAs for example. Historically, we have been persuaded by banking institutions to buy a Cash Mini ISA, as soon as the new tax year starts. There doesn’t seem to be any longer term planning involved here, just the sale of a product. I have nothing against Cash ISAs per se, but I have an issue with the lack of any planning involved in the sale. In fact, I have several problems with this.
1. I think this is generally a waste of the ISA allowance because cash only generates interest, with no possibility of any capital growth (which would be tax-free). For higher rate taxpayers who use their annual Capital Gains Tax allowance, the ISA is a very valuable tool in avoiding tax on further gains.
2. Serial Cash ISA savers then store up a pile of money in cash over a number of years. Cash is intended to be for short term liquidity. It is not for long term investment as inflation will erode its value over time. Any subsequent withdrawal from the Cash ISA means the loss of the tax-free allowance.
3. The sale of a Cash ISA automatically restricts the investor to a lower Stocks and Shares ISA allowance, and this cannot be reversed once sold. This means investors need to understand what they are doing and why, before they do it.
But there is some good news coming. From 6 April 2008, we will be able to switch Cash ISAs into Stocks and Shares ISAs. This will help people to retain the tax-free status of their Cash ISAs and invest in something more suitable as a long term investment. At the same time, we will be allowed to convert existing PEP accounts into ISAs, which will simplify the situation. The “Maxi” and “Mini” distinctions will disappear, and the ISA allowance is also rising from £7,000 to £7,200. Incidentally, I think the term Stocks & Shares ISA is misleading. This suggests that the only assets that can be held have to be shares. There is in fact a very wide range of assets that can be held with a range of risk profiles.
I would encourage you to think about your ISA allowance as a means of building a capital sum over the long term. This enables you to generate a fund from which you might draw a future income which is not subject to personal tax and which could be used to supplement taxable income, perhaps in retirement. This approach allows you to take a long term view with your ISA investments, which means investing in assets such as equities and property that are likely to generate real returns over time. Short term volatility and the timing of the initial investment, then becomes less important.
Of course, with ISAs, you always have control of all of the capital, so if you wish to spend the accumulated pot, then you can.