Hurry – if you want to avoid paying tax on your savings

With only seven weeks left until the end of the tax year, time is running out to make use of your annual ISA (Individual Savings Account) allowance. Not sure what all the fuss is about? Read on.

What are ISAs?

ISAs were introduced by the Labour government nine years ago, replacing PEPs and Tessas. They allow every UK taxpayer to save a certain amount of money each year, without having to ever pay any tax on the interest, dividends or capital gains.

Because each tax year runs from April to April, February and March tend be the busiest time of year for ISA sales – as investors rush to take advantage of their annual allowances before the start of the new tax year.

You can invest your annual ISA allowance into either a cash savings account, or into stocks and shares. However, the limits vary, depending on which mix you decide to go for.

How much can I invest in a cash ISA?

If you only want to invest your ISA allowance into a cash savings account, you need to take out a "mini cash ISA". In the current tax year, you can put a maximum of £3,000 into these types of accounts, rising to £3,600 in the 2008/09 tax year.

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What if I want to invest in stocks and shares as well?

If you want to invest some of your savings in the stock market, you can put up to £7,000 a year into a maxi stocks and shares ISA, rising to £7,200 a year from 6 April. If you want to invest in a mix of cash and stocks & shares, you can use up to £3,000 (£3,600 from 6 April) of your maxi ISA allowance for cash investments.

Can I invest my ISA in anything apart from cash and shares?

Yes. Most unit trusts, investment trusts and Oeics (open-ended investment companies) qualify for inclusion within a stocks and shares ISA.

There are several thousand of these funds to choose from in the UK, investing in everything from bonds to commercial property to commodities. For more details on non-equity investments for your ISA, see our article on pages 8 & 9.

How much tax will I save by using an ISA?

In a regular cash savings account - or a current account - any interest accrued will be taxed at 20 per cent (or 40 per cent if you're a higher-rate taxpayer). Therefore, if your account advertises a gross interest rate of 5 per cent, you would only receive 4 per cent after tax, or just 3 per cent if you're a higher rate taxpayer. Within an ISA, however, you receive the full gross rate.

On a £3,000 ISA, that's only a saving of £30 or £60 a year. However, someone who has used their full cash ISA allowance each year would now be saving several hundred pounds in tax every tax year.

Anna Bowes, of AWD Chase de Vere, the independent financial advisers, says using your cash ISA allowance should be a no-brainer. "If you're a UK taxpayer and you use your cash ISA allowance, you're getting an immediate cash benefit by not paying tax on your savings," she says. "When it comes to stocks and shares ISAs, however, there may not be any immediate benefit unless you are a higher-rate taxpayer."

Every UK taxpayer has a capital gains tax allowance of £9,200 a year – so unless your invest-ments grow by more than this in a single tax year, you wouldn't be liable to pay tax, even if they're not held within an ISA.

However, if you're earning an income from your ISA investments – by investing in bond funds, for example – you will have to pay tax, unless you hold the funds within an ISA.

While basic-rate taxpayers do not have to pay tax on share dividends, higher-rate taxpayers are taxed at 22.5 per cent. Within an ISA, however, they can avoid this.

For those who take full advantage of their ISA allowance each year, the tax-breaks can eventually amount to thousands of pounds a year.

Can I switch money from a cash ISA into a stocks and shares ISA?

As of 6 April, you will be able to transfer savings from cash ISAs into stocks and shares ISAs. However, Bowes points out that you cannot make a transfer back the other way, so you need to be sure of your decision before you go ahead.

How do I open an ISA?

If you're looking to put all your money into a single savings account or fund, the provider will usually be able to hand over all the paperwork you need to ensure your money ends up within an ISA wrapper.

For those who want to invest in a number of different funds, or who want to invest directly in individual shares, it's necessary to use a broker, such as TD Waterhouse (www.tdwaterhouse.co.uk) or The Share Centre (www.share.com), or a fund supermarket, such as Fidelity's FundsNetwork (www.fundsnetwork.co.uk).

If you need advice on where to put your money, you can find a financial adviser in your area, by visiting www.unbiased.co.uk