Ten years of tax-free saving

Individual Savings Accounts (ISAs) came to life in April 1999. Ten years on, we explain why these tax shelters are so valuable for savers and investors.

In his first Budget as Chancellor, Gordon Brown announced the introduction of a new type of tax shelter: the Individual Savings Account, or ISAs. ISAs were designed to encourage UK residents to save or invest for their future inside a tax-advantaged account.

A history of ISAs

ISAs were launched to great fanfare on 6 April 1999, but attracted a lot of criticism for their perceived complexity and inflexibility. Indeed, financial pundits very much preferred their forerunners (PEPs for stock-market investments and TESSAs for cash), which offered higher investment limits and a wider range of investments.

Nevertheless, Gordon Brown pushed on with his plans and ISAs have now been a feature of the savings landscape for almost a decade. During the past ten years, the ISA regime has been fiddled with, supposedly to make ISAs less complex and more attractive to the general public.

Initially, ISAs offered fairly modest savings limits per tax year, across three different elements:

• 1. a stock and shares maxi-ISA (up to £7,000);
• 2. a mini-cash ISA (up to £3,000); and
• 3. a life assurance ISA (up to £1,000).

A shaky start for savers

Frankly, this savings menu was overly complicated and badly thought-out, causing most savers and investors to steer clear of ISAs. What was particularly confusing was the mix 'n' match menu. For example, if you put any amount into a mini-cash ISA (even £1), then your limit for a stock and shares ISA fell to £4,000. Also, the life assurance ISA was largely ignored, leading to its ultimate demise in April 2005.

ISAs also suffered a setback when Gordon Brown abolished Advanced Corporation Tax (ACT). Under previous rules, investors in tax shelters could reclaim a 20% tax credit on dividends (the income paid by shares). To soften the blow, the Chancellor allowed ISA investors to claim a 10% tax credit on dividends, but this ended in April 2004.

Despite their limitations, ISAs got off to a good start, partly thanks to the 'tech bubble' (stock-market boom) of 1999/2000. In their first year, stocks and shares ISAs attracted £9 billion in contributions, but 9/11 and the bear market which lasted until March 2003 turned millions of people off investing in companies. Even when the stock market recovered between 2003 and 2008, ISA sales never reached their turn-of-the-century peak.

Nicer ISAs

Despite their shaky start, ISAs have become the cornerstone of tax-free saving and investing for millions of adults. At the end of the 2007/08 tax year, 14.7 million new ISAs were opened, with a total of £35.7 billion being paid into these accounts.

Alas, for most of their life, a question mark hung over ISAs, as the government was unwilling to give a lifelong commitment to these accounts. One worry was that ISAs were given a shelf life until 2010, after which the yearly tax-free allowance would end. Fortunately, the Treasury relented and agreed to keep these tax-free accounts in place beyond next tax year.

In July 2007, the ISA regime was overhauled and, from 6 April 2008, the following limits apply per tax year:

• you can save up to £3,600 in a cash ISA, which earns tax-free interest (minimum age: 16);
• you can invest up to £7,200 in a shares ISA, with no Capital Gains Tax to pay on profits and no extra tax to pay on dividends (minimum age: 18).

Note that there is an overall limit of £7,200, so if you put the full £3,600 into a cash ISA, then you can invest only £3,600 in a shares ISA in the same tax year. ISAs can be transferred from one provider to another, and you can transfer a cash ISA into a shares ISA without losing that year's allowance.

It's important to note that ISAs are best used for long-term saving, so they aren't really suitable for instant access. The best way to make full use of an ISA is to shelter your interest or other gains from tax over a long period. Nevertheless, most ISA money in held as cash, which accounts for roughly three-quarters (75%) of the total sum tucked away in these tax shelters.

The benefits of using an ISA

A cash ISA is broadly similar to a common or garden savings account, but any interest is paid free of tax (and this income doesn't have to be declared on your tax return). By saving inside an ISA, basic-rate taxpayers avoid the usual 20% savings tax; higher-rate taxpayers avoid 40% tax.

For investors who pay basic-rate tax, there is no tax advantage from earning dividends inside, rather than outside, an ISA. In both cases, a nominal 10% tax credit attached to the dividend cancels out your tax liability. However, higher-rate taxpayers normally pay tax on dividend income at 32.5% but, inside an ISA, this extra tax liability is avoided.

In addition, investors can avoid Capital Gains Tax (CGT) by using an ISA wrapper to shield their investments (shares, funds, index tracker, etc.). CGT is payable on gains of over £9,600 from the sale of certain assets in the 2008/09 tax year. Thus, it makes sense to use an ISA to limit your exposure to this tax, which is 18% of your taxable gain.

In summary, ISAs provide valuable tax benefits and now have a long-term future. They could even be upgraded in the next Budget. So, I recommend the Individual Savings Account to you as the bedrock of your financial road to riches!

PS. Don't forget to use your 2008/9 ISA allowance before 6 April, or it's gone forever!

More: Find a superior savings account | Draw a bigger income from your pension pot | Twenty years of DIY pensions

Comments are not gone forever!

We've had to take article comments down temporarily as we set up our new home on lovemoney.com, but new comment tools (and your old comments) will be back soon.