How to fill your ISA for free

The Individual Savings Account (ISA) is the favourite tax shelter of UK savers and investors.

In the 2008/09 tax year, UK residents opened 14.2 million new ISAs: 11.3 million cash ISAs and 2.9 million stocks and shares ISAs. The attractions of ISAs are obvious:

• Any UK resident aged 16+ can open a cash ISA; for shares ISAs, the minimum age is 18.
• Each tax year, you can contribute up to £5,100 into a cash ISA, plus the same amount into a shares ISA, for a total of £10,200 (and double this for couples).
• If you don’t put anything into a cash ISA, then you can put the maximum £10,200 into a shares ISA.
• Any interest you earn inside a cash ISA is complete free of tax, making it superior to an otherwise identical taxable savings account.
• Any capital gains (profits) made inside shares ISAs are tax free, as are any dividends (the income from shares) received. However, you cannot reclaim the 10% tax credit notionally attached to dividends.

In short, ISAs are a very tax-efficient way of saving and investing -- and every adult with spare cash should have one. ISAs have been around since 1999 and anyone making full use of their yearly ISA allowances could today have £100,000+ safely stashed away from the taxman.

Funding a cash ISA

The simplest way to fund a new cash ISA is to open a 2010/11 ISA right now and then deposit as much money as you can afford, either in one go or each month -- after shopping around for the highest rates, of course.

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By doing this, you money moves from a taxed to a tax-free savings account, which boosts your interest. For example, 3% interest in a tax-free ISA is equal to 3.75% interest for basic-rate (20%) taxpayers. For higher-rate taxpayers, 3% untaxed is worth 5% taxed, which is a big boost.

Here’s another tip: when sorting out a new ISA, don’t forget about your existing ISAs. A recent review found that most cash ISAs pay yearly interest of 0.1% to 0.5%, which is rubbish. Thus, arrange to transfer your ISA cash from existing providers to a Best Buy account which accepts ISA transfers. By doing so, you could boost your tax-free interest rate to between 3% and 5% a year.

For example, I recently helped a couple of lovemoney.com readers to grab higher rates by transferring their cash ISAs to Best Buy accounts. In their existing ISAs, they had built up £35,000, but this was earning around 0.4% a year. Thus, their tax-free ISA income was a measly £140 a year.

After consulting the Best Buy tables, they opted to move to a five-year, fixed-rate ISA paying 5% a year. This boosts their tax-free interest to £1,750 a year, leaving them £1,610 a year better off. It’s as easy as that!

Funding a shares ISA

Although these are referred to as ‘stocks and shares’ ISAs, investors can use them to shelter a wide variety of investments from the taxman. These include shares in individual companies (in a ‘self-select ISA’), corporate bonds (IOUs issued by companies that pay a fixed rate of interest) and funds such as index trackers, unit trusts, OEICs (open-ended investment companies) and exchange-traded funds (ETFs).

If you have plenty of cash squirreled away, then the easiest thing is to deposit this cash inside a shares ISA and then use it to buy investments which take your fancy.

• Watch our video: How to invest in your first stocks and shares ISA

However, you don’t need fresh cash to fund a new shares ISA. Although you can’t transfer shares straight into an ISA, you can do something sneaky which is called ‘Bed and ISA’. This involves your ISA manager selling your existing investments and then buying them back inside an ISA.

Why bother doing this?

First, it allows you to save future taxes on existing investments by sheltering them inside a tax-free wrapper. Second, it enables you to ‘crystallise’ existing capital gains (or losses), thus using up part of your yearly capital gains tax allowance. (The CGT allowance for 2010/10 is £10,100.)

However, there may be costs involved in a Bed and ISA transaction, such as:

• Two lots of share-dealing charges: for selling your shares and buying them back inside an ISA. Then again, do shop around, as some ISA managers offer commission-free Bed and ISAs.
• Stamp duty of 0.5% of the value of shares bought inside the ISA (£1 for every £200 invested).
• The ‘bid-offer spread’, which is the difference between the (lower) selling price and the (higher) buying price of the shares. However, given that you are both buyer and seller, your ISA manager should be able to negotiate a minimal spread with the market-makers who trade shares.
• Once your shares are inside an ISA, you may be charged monthly, quarterly or yearly management fees and/or inactivity fees. Therefore, carefully check all charges before opening a shares ISA.
• You cannot transfer shares quoted on AIM (the Alternative Investment Market) into a shares ISA, although this rule is to be reviewed.

Finally, you can switch savings built up inside a cash ISA into a stocks and shares ISA, but not the other way around. This could be useful for investors looking to boost their tax-free income by moving into high-yielding shares or corporate bonds However, this higher income comes at far greater risk, so please do your homework before switching!

Get help from lovemoney.com

If you have any questions about tax-free saving, then ask other lovemoney.com readers for help via Q&A. Also, to save as much as you can, join our Build up your savings goal.

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