Investing in an ISA is a way of being able to make tax free investments. People can invest up to the ISA allowance amount each year through cash ISA’s and stocks and shares ISA’s. Up to half the amount can be invested in a cash ISA, but if savers choose they can use 100 per cent of it for a stocks and shares ISA. The advantage of an ISA compared to other investments is that increases in the value of investments are not taxed, with no tax paid on interest or capital gains.

The ISA allowance is an amount set each year as the maximum any individual can invest in ISA’s that year. This limit is set to prevent people from being able to invest an unlimited amount, and therefore receive an unlimited amount of non-taxable income. The ISA allowance is re-evaluated each year, with a limit set for the duration of a tax year (sixth April to fifth April the following year).

In the tax year 2011/2012 the allowance was £10,680, so up to £5,340 can be invested in a cash ISA. This will be increasing by 5.62% to a total of £11,280 in 2012/2013, so up to £5,640 in a cash ISA. To make full use of the allowance, investors must use it within the tax year; it cannot be carried over to the following year. For example, if someone has invested £8,000 in 2011/2012 they do not have an allowance of £13,960 in 2012/2013. The allowance is reset to £11,280. For this reason it is worth using the full allowance prior to the end of the tax year where possible.

The purpose of an ISA is to encourage savings and investment. Anyone can invest and they don’t have to invest the full amount. People are encouraged to invest by the tax advantages. The limit prevents the possibility of some potentially investing very high amounts each year and, therefore, paying less in tax. Were this to be the case it would allow the very wealthy to make large tax savings. The overall objective is to encourage saving and investment without making it too easy for some to avoid tax.

As touched upon above, there are two types of ISA; a cash ISA and a stocks and shares ISA. A cash ISA is the safer bet but, due to this, the potential gains are not so high. A stocks and shares ISA is the opposite; riskier but the gains are likely to be higher with the more successful investments. Having these two options gives people a choice. And, of course, they can mix and match. They cannot, though, put more than a certain limit towards a cash ISA. The cash ISA allowances for both 2011/2012 and 2012/2013 are half of the total, but this has not always been the same. In most cases investments in stocks and shares ISA’s are more beneficial over the long term, but this cannot be guaranteed. It depends on the specific investments, with some performing better than others.

Andrew Marshall ©