ISAs and PEPs are not types of investments in themselves but ‘wrappers’ which can be placed around various types of investment in order to get tax advantages. So it is necessary to choose the type of investment you wish to make within the ISA or PEP.

CHOOSING INDIVIDUAL SAVINGS ACCOUNTS

ISAs replaced PEPs and TESSAs for new investments after April 1999 and are guaranteed to run for ten years. The annual limit for investment is £7,000 (£5,000 from April 2006). Income and capital gains in an ISA are tax-free and dividends receive a 10% tax credit until 2004. Investments can be in three components:

• up to £3,000 (£1,000 from April 2006) in a cash component – in banks, building societies, National Savings products (the taxable ones of course);
• up to £1,000 in an insurance component -single-premium life assurance policies such as with-profits bonds;
• up to the full £7,000 (£5,000) in stocks and shares -investment or unit trusts, preference shares, bonds and gilts or directly in equities (a self-select ISA). There are no geographical limits as there were for PEPs.

There is a question mark over the value of the insurance component because insurance-linked products pay income tax (albeit at a favourable rate), which cannot be recovered and no more tax is payable on investments outside an ISA except for higher-rate taxpayers.

Shares arising from employee share option schemes (See Chapter 5) can be transferred to a stocks and shares ISA without counting against the annual limit.

Although 18 is the starting age for ISAs, 16 and 17 year-olds can invest up to £3,000 (£1,000 from 2006) in a cash ISA.

There are three kinds of ISA:

• Maxi-ISAs – up to the full £7,000 (£5,000) is invested with one provider, although it can still be broken down into two or three components.
• Mini-ISAs – you can have one, two or three providers, one for cash, one for insurance and one for stocks and shares (but you cannot forgo either the cash or insurance mini-ISA to put £4,000 in stocks and shares).
• TESSA-only ISAs – when a TESSA expires, the capital element (but not the interest) can be re-invested in a cash or TESSA-only ISA without counting towards the annual ISA limit.

You cannot invest in both a maxi-ISA and a mini-ISA in the same year.

Income can be left in or withdrawn but once taken out neither income or capital can be put back into that year’s ISA.

CAT standards exist for ISAs (charges, access, terms) to protect inexperienced investors but providers do not have to follow them. See Figure 9 for details.

Are they good value?

There has been some debate about the value of PEPs, particularly for standard-rate taxpayers, since not many people pay capital gains tax and the extra charges could be greater than the income tax savings. However, this dates

back to the time when PEPs could only be invested in equities. The same questions arise in connection with ISAs.

Figure 10 tabulates the return required to recover the annual charges.

Statistics of returns over a period are only available for the time when PEPs were limited to equities. They show that equity investment through a PEP achieved a higher return although it took a lengthy period for the difference to be significant (see Figure 11).

Corporate bond ISAs and PEPs

Now that ISAs and PEPs can be invested in company fixed-interest stocks and shares, producing more income than equities at least to start with (as well as incurring less risk), there will be a tendency, particularly in the case of higher-rate taxpayers, to use ISAs and PEPs in this way.

Another reason is that the full amount of tax deducted at source from company fixed-interest stocks can be recovered by the ISA manager instead of the limited recovery of tax deducted from dividends.

Choosing an ISA

Even when you have decided on the type of ISA you wish to invest in, there is still a wide choice. Here are some questions to ask the ISA provider:

• What are the initial/exit and annual charges and are they charged to income or capital?
• What are the dealing costs (if applicable)?
• What is the charge for transfer to another provider?
• Is there any charge for switching between the provider’s own funds?
• Are there charges for collecting dividends, getting company reports and attending AGMs?

It is possible to have a self-select share ISA in which you choose which shares or units to invest in and you can trade

in the usual way (this also applies to PEPs). There is no specified limit as to how long you can hold cash – the criterion is an intention to invest.

Putting all your annual share ISA money into one unit or investment trust, while economical, can be somewhat risky, especially in the case of an ISA mortgage, but you can spread the risk by choosing a different investment sector for each ISA year.

Fund supermarkets (See Chapter 4 under unit trusts) are worth considering for ISAs.

Further information

There is a great deal of information on ISAs, mostly from investment or unit trust providers. Usually you can choose which funds to invest in from those made available by the provider.

The Association of Investment Trusts (AITC) has a guide on investment trust ISAs and many discount brokers produce guides from time to time. There is also an Inland Revenue leaflet IR89. See Appendix B for how to obtain any of these.

KEEPING UP YOUR PERSONAL EQUITY PLANS

While these are not available for new business, existing PEPs can be retained. All income and capital gains within a PEP are free of tax. Also PEPs will continue to receive a 10% tax credit on dividends until 5 April 2004.

There are still general PEPs and single-company PEPs, the latter being limited to one company, but the two can now be merged, so the restriction to a single company can now be avoided. Also, transfer of part only of a PEP is now permitted.

Investments in PEPs can be changed, the only limitation being that in a single-company PEP the proceeds of the sale must be reinvested within 42 days. There is no limit to the time that money in a general PEP can be left on deposit in cash form, providing there is an intention to reinvest.

The qualifying rules have now been extended from the previous more limited rules to the same rules as for ISAs.

DEALING WITH YOUR TAX-EXEMPT SPECIAL SAVINGS ACCOUNT

It is the interest which is exempt from income tax. The maximum investment was £3,000 for the first year and £1,800 a year thereafter, up to a maximum of £9,000.

The money has to be left in for five years from commencement to get the tax exemption, although it is possible to take monthly payments of the non-tax-free element of the interest, i.e. 80% of it.

It is possible to cancel the contract and withdraw the full amount (but not part) within the five years but the tax exemption is entirely lost. It is also possible to transfer from one provider to another, although the provider may impose penalties.

TESSA savers trapped in accounts with low rates of interest can now get compensation. Claim from your provider and if necessary take it up with the appropriate Ombudsman.

TESSAs are not available for new investment but existing TESSAs run till maturity and then the capital element (up to £9,000) can be transferred into a cash ISA or a TESSA-only ISA without affecting the current year’s ISA limit.

The interest element of the TESSA cannot be rolled over into an ISA without affecting the current year’s allowance but interest subsequently earned in an ISA can be left in.

There is no minimum period of investment for an ISA, as was the case for a TESSA, but once cash is withdrawn it cannot be reinvested without counting towards the current year’s ISA limit.

A TESSA-only ISA enables you to move your TESSA savings away from a cash ISA into a stocks and shares ISA.

CASE SCENARIOS

Amanda buys a maxi-ISA

Amanda wishes to take full advantage of the tax saving on ISAs and decides to set up a self-select maxi-ISA so that she can choose her own investments. With £7,000 to invest this year, she chooses two shares from her ‘system’.

Alistair and Jean choose mini-ISAs

Alistair and Jean wish to spread their investments so decide to put £3,000 in a cash mini-ISA, £1,000 in an insurance mini-ISA and the balance of £3,000 in a unit trust stocks and shares mini-ISA.

They would prefer not to invest in the insurance component if they could increase their investment in one of the other categories, but this is not permitted.

Gwen and Hugh discuss their TESSA

Gwen and Hugh started a TESSA when TESSAs first began and on maturity the capital value was rolled over into a ‘second-generation’ TESSA, which is due to reach maturity in 2003.

By then, Hugh will have retired and they will need income, but they think they will roll over the capital value again to preserve it, and then draw out the interest on a monthly basis.

POINTS TO CONSIDER FURTHER

• 1.What are the relative merits of maxi- and mini-ISAs?
• 2.Why is the insurance component of an ISA not as attractive as the other two components?
• 3.If you have a PEP and cannot afford to start an ISA this year, what are the advantages and disadvantages of cashing in the PEP and reinvesting the proceeds in an ISA?