- guardian.co.uk, Wednesday 15 April 2009 15.48 BST
An Isa is a tax-efficient "wrapper" in which you can hold either stock market-based investments or a traditional savings account.
Any interest earned on savings or bonds and any capital gains made on investments within an Isa are tax free. This makes Isas particularly appealing to higher rate taxpayers, who usually have to hand over 40% of their returns to the tax man.
Isas replaced personal equity plans (Peps) and tax exempt special savings accounts (Tessas), which closed to new investors in April 1999. Two types of Isas are available: stocks and shares Isas and cash Isas.
Because of the associated tax breaks, the amount that can be invested in an Isa each tax year is limited.
In October 2009, the limit for savers aged 50 and over was increased to £10,200; younger savers will benefit from the same increase from 6 April 2010. In the meantime they can hold up to £7,200 in an Isa.
How the money is divided depends on the kind of assets people want to hold.
Investment limits
The old distinctions between maxi and mini Isas no longer exist – they were scrapped in April 2008.
Instead, if you are under 50 you can invest your £7,200 allowance in two ways:
• Put all £7,200 in stocks and shares, or
• Up to £3,600 in cash and the balance in stocks and shares.
If you are aged 50 or over you can invest your £10,200 in two ways:
• Put all £10,200 in stocks and shares, or
• Up to £5,100 in cash and the balance in stocks and shares.
A cash Isa can be held with one provider and the remainder of the overall allowance in a stocks and shares Isa from another provider, or it can all be held with the same company.
Investors cannot pay in more than the annual limit, even if they have made a withdrawal. If, for example, someone pays in the full £7,200 or £10,200 but takes out £2,000 the next month, they cannot put that £2,000 back in an Isa in the same tax year. The Isa holding may be below the limit but they will be deemed to have used their annual allowance.
Cash Isas
A cash Isa is a tax-free savings account, usually offered by a bank or building society. It keeps an initial investment intact, and usually offers a higher rate of interest than taxed accounts from the same bank or building society which is tax free.
Some Isa providers offer cash funds, which invest in the money markets and target a set return above the Bank of England base rate. In exchange for greater potential return investors will pay an annual management fee and may be locked into the investment for a set term.
Stocks and shares Isas
Also referred to as equity Isas. A stocks and shares Isa can hold an investment fund or funds, or individual stocks and shares. This type of Isa carries risks, and should be regarded as a medium- to long-term investment.
An investor can put their full allowance in stocks and shares, but if they want to reduce their risk they may prefer to hold some of the allowance in cash.
If they want instant access to their money, a cash Isa will probably suit them better. But if they are thinking of investing money they can afford to lock away, they should consider shares.
If they wish to invest in a range of funds from different providers – or to benefit from lower initial charges – they should considerg a fund supermarket, either directly or through an independent financial adviser (IFA), or a discount broker. These will offer a menu of funds from which a selection is on offer, subject to minimum investment levels in each.
Self-select Isas
These are designed for investors who want to hold individual stocks and shares and are offered by stockbrokers and online share dealing sites.
An investor can buy up to £7,200 (or £10,200) worth of shares through the Isa provider. As with share deals done outside the wrapper, there will be costs associated with buying and selling stocks. These will be on top of any charge for the Isa wrapper.
Tax advantages
Basic rate taxpayers who are usually taxed at 20% on interest earned on savings accounts and bond funds do not pay a penny on interest earned on a cash Isa. Higher rate taxpayers make bigger tax savings, as they usually face 40% tax.
The tax benefits on stocks and shares Isas are not as good as when they were first launched. Initially, investors could reclaim the 10% tax paid on dividends (income paid to people who hold shares), but in April 2004 the 10% dividend tax credit was scrapped so for basic rate taxpayers dividends are taxed as outside the Isa wrapper.
Higher rate taxpayers still gain from holding dividend-producing shares in an Isa – they pay tax at 10% rather than the 32.5% that is deducted on non-Isa investments.
Profits from shares held in an Isa are not subject to capital gains tax, which means any growth on your investment is all yours. You don't even have to declare your Isa on your tax return.
Transferring money
Isa can be transferred from a previous tax year from one provider to another without having an impact on the current year's allowance.
However, most of the best-buy cash Isas do not accept transfers in, so investors shopping around for a new home for last year's cash Isa need to make sure they read the small print before comparing rates.
Money from a cash Isa can be transferred into a stocks and shares Isa. If the cash Isa was from a previous tax year, an investor can move as much or a little as they like.
If the cash Isa is from the current tax year, they must move all of it. They will, however, be free to invest up to £3,600 (or £5,100) in another cash Isa, subject to the overall investment limit of £7,200 (£10,200).
Transfers from stocks to cash are not allowed.