A guide to stocks and shares ISAs

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Are you thinking of investing in an ISA? With interest rates on savings accounts so low it may be tempting to consider investing instead. The advantage of investing in a stocks and shares ISA is that there’s no capital gains tax to pay when you cash them in. But how do they work?

A guide to stocks and shares ISAs

Most stocks and shares ISAs invest most or all of your money in company shares – normally by investing in a share-based fund, such as a unit trust or investment trust. Your money is pooled with that of other investors, and the idea is that your money grows over time. The advantage of a stocks and shares ISA, rather than investing in the funds directly, is that there’s no extra tax to pay when you come to cash it in.

Having said that, not all stocks and shares ISAs invest in company shares. Some invest in bonds. These are basically IOUs for loans to companies or governments.  Others invest in a mixture of assets, such as shares, bonds and even commercial property. Innovative finance ISAs let you invest in peer-to-peer loans.

There are two elements to a stocks and shares ISA.

  • The ISA wrapper: The part that makes ISAs tax efficient is the ‘wrapper’, not the investments themselves.  By investing in a stocks and shares ISA, you’re given some tax benefits. It’s like wrapping a present; the wrapper might make the present a little more appealing, but it’s what’s inside the wrapper that counts. No matter how beautifully wrapped it is, if the present isn’t right for you, you still won’t like it.

SAVVY TIP: Stocks and shares ISAs are not tax free. Instead, they are described as tax efficient. Why is this? The reason stocks and shares ISAs are not tax free is that some tax is already paid by the investments. However, they are tax efficient – and when you cash your ISA in you won’t have to pay any capital gains tax.

  • The investments: This is the important bit. How well or badly your ISA performs will come down to what it invests in, rather than the fact that you won’t have to pay tax when you cash it in. There’s a huge range of stocks and shares ISAs on offer which can invest in anything from relatively low risk government bonds to high risk shares in companies based outside the UK.

Choosing your stocks and shares ISA investments

If you feel comfortable doing your own research, you can choose which ISA fund (or funds) you want to invest in by going to an investment platform or fund supermarket. You get access to a wide range of stocks and shares ISAs, but you won’t get any advice about the best investment for you.

SAVVY TIP: The most logical thing might be to go direct to the company that sells the ISA you want to invest in but, by doing that, you may pay higher upfront fees.

If you don’t know what type of stocks and shares ISA you’d like, you’re best off getting advice from an independent financial adviser. There’s more about how to how to find an independent financial adviser you can trust elsewhere in this section.

SAVVY TIP: It may be tempting to choose a popular fund or a fund that is heavily advertised online or in the papers. However, it’s important to think about how a stocks and shares ISA fits in with your other investments.

What you can invest in

If you can’t afford to lose any of your money, you shouldn’t invest in a stocks and shares ISA. However, if you are happy to take some risk, a stocks and shares ISA may be for you.  You should be prepared to leave your money invested in the stocks and shares ISA for a minimum of five years.

SAVVY TIP: I always invest for at least ten years because I think that gives me the best chance of my investments recovering from any sharp fall in prices.

You can invest in:

  • Shares. Most people who take out a stocks and shares ISA choose a fund that buys shares in dozens of different companies. Some share-based funds will invest mainly in large UK-based companies, others may buy smaller and riskier businesses (or a mixture of the two).

SAVVY TIP: Many share-based funds are ‘actively managed’ which means there’s a team of fund managers who decide which shares to buy and sell and when to do it. There’s a big debate in the industry about whether it’s useful to look at how well a fund performed in the past to predict whether or not it will do well in the future. My view is that there’s no simple answer, but it’s definitely the case that some managers have been consistently bad. Websites such as Trustnet and Morningstar let you compare performance of different funds.

  • Bonds. There are two main types of bonds that a ‘stocks and shares’ ISA could invest in. The first is corporate bonds. These are basically IOUs for loans made to companies. The second is gilts, which are bonds issued by the UK government when it wants to raise money.

SAVVY TIP: A mistake that many investors make is to split their money between different share-based funds, without thinking about other assets, such as bonds.

Don’t forget the charges

If you take out a cash ISA you don’t have to pay charges every year for the the bank or building society to look after your money. The bank makes its money by paying you less interest than it receives when it lends money. With stocks and shares ISAs, the ISA provider will take ongoing fees for managing your money. There may be upfront fees as well.

SAVVY TIP: If you invest your money in an ordinary (non tax efficient) pooled investment fund, you still have to pay the same charges. In fact, some companies charge a little less if you invest through an ISA.

Related articles:

Transfer a stocks and shares ISA – what you need to know

What is a stock market or stock exchange and how can you invest?

VIDEO: Dividends from shares explained

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