How to get the most out of your ISA

Earlier this year there was plenty of concern about the effect that extremely low rates were having on those who rely upon the interest from savings to boost their income, with much of the sympathy reserved for the plight of pensioners.

In the year or so since the UK's economy was knocked sideways by the credit crunch, we have seen the Bank of England's base rate rapidly fall down from 5 per cent in September 2008 to its current level of 0.5 per cent, where it has stood since March this year.

Over the same period the average monthly interest rate for a £10,000 balance in an instant-access account reduced from 4.19 per cent down to just 0.88 per cent. To put that in perspective, that resulted in a fall in monthly interest from £34.91 down to £7.33 for non-taxpayers.

Against that backdrop, the Government rushed out a surprise increase in the annual Individual Savings Account (ISA) allowance from £7,200 up to £10,200. It will be phased in on 6 October 2009 for those aged 50 or over (by 6 April 2010) and from 6 April 2010 for all other ISA savers.

Presently, up to £7,200 can be invested in a stocks and shares ISA – or up to £3,600 in a cash ISA, with the option of putting the remains of the annual allowance in a stocks and shares ISA. When the increase comes into effect, up to £5,100 may be invested in a cash ISA.

The changes have stirred up something of a hornet's nest among providers, who could have done without the change being implemented during a tax year. Computer systems can't always cope with such changes and one can only imagine the bedlam that it has caused in IT departments.

Very few banks and building societies have yet revealed how they're going to deal with the October change, but there are three different types of people aged 50 or over affected by the new rules. First are those who will not, by 6 October, have used any of their cash ISA allowance – they should not have any problems in finding a cash ISA home for up to £5,100.

There is also a group of people – probably the vast majority – who have already put some money into a variable-rate cash ISA for this tax year and who should not have any problems topping up the additional allowance as well.

However, there are potential problems for a third group – those who have already used some of this year's cash ISA allowance by investing in a fixed-interest rate ISA.

Most fixed-rate offerings are for one-off lump sums and have terms and conditions that preclude further investments. If the ISA company is willing to vary that condition and permit an additional top-up, the second issue is whether the company will be offering the same fixed interest rate.

The majority of available interest rates are higher now than they were back in, say, April, so you may want a better return than that being paid on your existing fixed rate.

If you want to take advantage of the increased allowance, the first thing to do is to contact your provider to find out whether they will permit you to top up your ISA. Some may still be deciding what to do so it's possible that they may not be able to give you an answer until nearer 6 October.

If they are not willing to let you top up, it is probably worth asking whether they will waive any penalties that might have been imposed if you transfer your ISA elsewhere.

You can't open two cash ISAs for the same tax year, but if you've already opened a cash ISA this tax year you should be able to transfer it from one company to another. If you do so, remember that the correct way to do this is to fill in the forms at your intended new ISA company and then they will arrange for the funds to be transferred. Don't just withdraw the funds, otherwise you'll lose the tax-free allowance.

Clearly it's down to each saver's preference and attitude to risk as to whether they want to use a cash ISA or a stocks-and-shares ISA, but it is important to note that each year's allowance is on a use-it-or-lose-it basis. Interest rates payable on cash ISAs may look very low at the moment but, if you use each year's allowance, you will build up a tidy capital balance, which may benefit from much higher interest rates in future years.

Some savers who have invested the full amount every year in cash ISAs and their predecessor, tax exempt special savings accounts (Tessas), may, by now, have more than £50,000 shielded from tax. Even at the average cash ISA rate of 2.04 per cent, this sum would earn annual interest of £1,020 or, at the highest available fixed rate of 4.6 per cent, some £2,300.

With variable-rate savings accounts, it is worth checking regularly what interest rate you are being paid as it is possible you can get a better return by transferring to an alternative company.

Cash ISAs are no different. For example, Cheltenham & Gloucester's Cash ISA pays just 0.05 per cent gross which, for a £3,600 balance, would pay annual interest of £1.80. This 0.05 per cent rate can be easily bettered elsewhere. However, not all cash ISAs will permit transfers in from other cash ISAs and some ISAs are restricted to investments of this year's allowance only.

The tax-free status of cash ISAs means that they are even worth using by those taxpayers who cannot afford to put money away for lengthy periods and effectively need a transactional account. If that's the case make sure you pick a genuinely instant or easy access account, which does not restrict the number of withdrawals or impose any penalties.

David Black is a money analyst at Defaqto