Using your ISA allocation wisely

While ISAs are well known for being tax-efficient, it is also important to select the right kind of underlying investment. Using your ISA allocation wisely does not just mean picking a reliable and successful ISA provider, it also entails giving careful consideration to the actual assets themselves. The reason for this is that not all asset classes receive the same tax benefits within an ISA wrapper. This can be confusing.

For example, cash ISAs are free of income tax. If you decide to invest in bonds through your ISA, you also pay no income tax. Meanwhile, interest-paying bond funds qualify for a tax credit of 20%, so the income (whether paid as income or re-invested)is totally tax-free. However, if you do opt for such a scheme over the cash option, remember that, unlike cash, the latter can put the value of your capital at risk.

Some corporate bond funds also have exposure to UK government bonds (known as gilts), which are also free from income tax, and are even lower risk – the chance of the Government defaulting on its loans is negligible. Alternatively, you could choose a gilt fund, which invests in a range of government bonds. Do note that, if you choose to invest in gilts directly, you’ll need to ensure the bonds have at least five years to run until maturity. With any bond ISA investment, the hope is that income payments will be supplemented by capital growth, but of course, there are no guarantees.

When compared with bonds, using your ISA to invest in stocks and shares is a little less effective from an income tax perspective. This is because, since April 2004, the rules have changed slightly. Basic rate taxpayers pay 10% tax on dividend income, which is taken before any dividend is received and now cannot be refunded, even within an ISA. Higher rate taxpayers, however, who would normally pay tax on dividend income at 32.5% outside an ISA, won't get back that 10%, but will save the remaining 22.5%.

Having said this, it is worth noting that although stocks and shares are seen as higher- risk investments, the asset class has outperformed bonds and cash over the long term and therefore the fact no capital gains tax is payable could be very important. However, none of this outweighs the need to ensure your investment choices are right for your needs. Only after you have got that right can you start thinking about how the tax breaks might help.

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