Looking to invest in an Isa? Here's what you absolutely must know before you commit your cash.
The average stocks and shares Isa fund grew 15.8% in the last tax year (2016/17), according to moneyfacts. Compare that to the measly 1.01% cash Isas returned, stocks and shares isas earned their investors 15 times as much as cash Isas.
Table 1: Example of returns for Stocks and Shares ISA Vs a Cash ISA
If that isn't an incentive to know more about stocks and shares isas, then what about the difference between your cash isa interest rate and the inflation rate? This is where it gets really interesting.
May saw the highest inflation rate since July 2013 at 2.9%, exceeding the Bank of England’s 2% target. Consumer confidence is growing, people are buying more and driving up prices. This can only be good for the economy, right?
There are certainly benefits, but it has a detrimental effect on savers. If your cash Isa earns you 1% whilst inflation is near 3%, the purchasing power of your savings decreases. Despite your money growing, it is not growing to the extent it needs to. It needs to work harder!
Here is one of the only savings accounts that can beat inflation.
What are Stocks and Shares Isas and How Do They Work?
A cash Isa is a savings account that allows you to earn interest tax-free. In comparison, a stocks and shares isa, also known as an investment Isa, is a way to invest in a variety of markets whilst still retaining the tax efficiency of a traditional Isa.
The investment vehicles for opening a stocks and shares Isa include investment trusts, unit trusts, open-ended investment companies (OEICs), government and corporate bonds. All of these allow you to cover a variety of asset classes.
Source: Tilney BestInvest. Data correct as at 07 August 2017. Aggressive growth.
They work the same way as a cash Isa in terms of opening and depositing. The difference is how the money is managed. The cash Isa will sit in that account and earn tax-free interest. The stocks and shares Isa is divided up based on your investment preferences – you make the final decision about where your money goes.
Deciding what to invest in can be a stressful process because there are so many options that you can end up second guessing yourself and over-analysing every little aspect.
There is no right way to decide where to invest. Ultimatley, it comes down to your lifestyle, timeframe and risk tolerance.
Why Choose a Stocks and Share Isa?
Investors who choose stocks and shares Isas tend to have one of two goals;
– To generate a supplementary income (via dividends or interest)
– To build a large value of investments (through share price appreciation)
Stocks and shares Isas have two main attractions:
1- Any profit you make is tax-free
2- Better returns compared to other investment/savings accounts
You must be aware that you are investing and not saving when using a stocks and shares Isa. If the idea of having your hard-earned cash exposed to market volatility keeps you up at night, a stocks and shares Isa is probably not for you. You have the choice of risk level, but it will be considerably higher than that of a savings account.
Picture 1: Nutmeg's Risk/Reward Scale
You must understand that you are taking on increased risk of capital loss. Ideally, any investment you make should be made for the long-term, which would be considered as a minimum of 5-10 years. If you think you may need the cash sooner, it is advisable to stick to cash Isas.
You can use a stocks and shares Isa as an alternative to a pension (or to supplement your pension), or you can use it to take an income over time.
Alternative Options to Stocks and Shares Isas
Cash Isa's offer tax-free interest payments. It is a savings account and so is considered extremely low risk. Part and parcel of low risk is low return, which is no different with cash Isas. At the time of writing, the best rates on cash Isa's are below the consumer price index (CPI), which is the main indicator for inflation.
If this continues for the duration of your savings being held there, your nest egg will lose value. This is because the monetary value of goods and services are increasing quicker than that of your cash isa. Your savings will have less purchasing power come the end of a 5-year fixed rate.
Cash Isas are usually quite flexible and allow you to take your money when you need it, which means they are good for the short-term.
Another benefit cash Isas have over a stock and shares Isa is that, should the fund go bust, the investor is covered up to £85,000, rather than the £50,000 limit that stock and share isas have.
A pension, as the name suggests, is a long-term investment and is a plan to provide retirement income security for the remaining life of the plan member. One of the most attractive features of a pension is the tax-free investment growth. Almost 'free money' from the taxman, who will give you a 20% top-up on what you have. This means your £20,000 in an Isa pot would be worth £25,000 in a pension.
It is difficult to define your rate of return in a pension, but most retirement calculators give an expected growth rate of 7%, based on a 60:40 equities/bonds split after inflation.
Pensions are less flexible. Accessing them before the age of 55 is not what they were intended for and can cost you 55% in a tax bill! If you think you'll need the money before then, stick to other investment avenues.
Stock Market: Bigger Risk, Bigger Reward
The stock market offers investment potential with considerably higher risks but potentially higher returns. Most stocks can now be found on large exchanges and are very liquid. This increases flexibility because it is easy to turn any shares you have quickly back into cash.
Dependent on your investment strategy, these can be considered short or long-term investments. The ability to offer dividends and, in turn, a passive income is an attractive feature of stock market investing.
Risks of Stock and Shares Isas
Fixed rate cash Isas can guarantee a level of return unlike stocks and shares Isas. This increased uncertainty can cause investor anxiety. Avoid stocks and shares Isas if they keep you up at night.
The fact that you are essentially participating in the stock market when opening a stocks and shares Isa exposes you to market risks.
Stocks and Shares Isa Charges and Limits
There is a limit to how much you can invest in an Isa every year. In the last two tax years (2015/16 & 2016/17), you could hold up to £15,240 in either a cash or stocks and shares Isa. The value in the latest tax year (2017/18) has increased to £20,000.
If you were to invest £10,000 in the first half of the year and your pot increased by 5%, your Isa account would read £10,500. You can still invest another £10,000, taking your account above £20,000. The same applies if you sell any shares within your Isa, the proceeds can still be used within that annual quota.
While stocks and shares Isas are tax-free, you are still charged certain fees depending on the investment type you go for. Charges are usually no higher than those you would pay for other investment products.
The individual Isas will usually charge a few different fees. These include an initial fee, management fee, and a platform fee. They used to be able to charge a commission on performance but due to regulatory changes that is no longer the case.
It is important to read the fine print and not take the headline rate without doing your research. Different fund managers will charge different rates and it's important to shop around for the best rates.
Who should I open a Stocks and Shares Isa with?
Minimum deposit – £100 lump sum or £25 per month
Charges – Starts at 0.45% up to the first £250,000 and then reduces the larger your account is. They will not charge you over £45 per annum to hold shares, bonds, investment trusts, ETFs or gilts.
Extras – They offer a ready-made portfolio that you can invest in straight away, hassle free. The minimum deposit increases to £1,000 with this option.
Minimum deposit – "The minimum investment into most funds is £50, with some funds being £100". Their website makes it difficult to decipher which minimum deposit the stocks and shares Isa fall under.
Charges – 0.4% up to £250,000, 0.2% – £250,000 to £1 million, no charge over £1 million.
Extras – They offer an investment advisory service.
Minimum deposit – £500 lump sum or £50 a month.
Charges – Up to £7,499 there is a flat annual rate of £45, or £25 for junior Isas. Up to £249,999, the fee is 0.35% and 0.20% over that. Like Hargreaves Landsdown, there is a £45 fee cap for ETFs and investment trusts.
Extras – 24/7 online account access
Both BestInvest and Hargreaves Lansdown offer advisory or ready-made portfolios, but if you want someone to invest on your behalf you can also look at companies like Nutmeg, Moneyfarm and Wealthify.
Nutmeg offer a fully managed Isa, where their team makes strategic adjustments to your portfolio to protect losses and boost gains. They also offer a fixed allocation, whereby they design the portfolio according to your risk tolerance and then leave it alone.