Savers to turn a cold shoulder to £3,000 extra ISA allowance

Millions of Britons are ready to look a gift horse in the mouth. In six weeks' time, the amount of money that savers can pay into an individual savings account (ISA) will rise by £3,000, yet a National Savings & Investments (NS&I) survey has found that just 15 per cent of Britons understand the new limits, and a quarter incorrectly believe the allowances will remain the same.

From 6 April, everyone will see their ISA allowance rise from £7,200 to £10,200, as it did back in October 2009 for the over-50s. The increase will be of particular benefit to higher-rate taxpayers and, with the new 50 per cent tax bracket being introduced at the same time, protection against taxation will be even more crucial. So, with the bonus £3,000 and the considerable tax benefits on offer, why are many savers still reluctant to put their cash into an ISA?

Much of the apathy lies in a lack of understanding about the way ISAs work in general and disappointment in the rates available. According to NS&I's poll, 16 per cent haven't invested in an ISA because they find it confusing, and 35 per cent have been put off by the low rates on offer.

It is true that rates are far less appealing than they once were, but are savers missing out by not making the most of their allowance? New research by Clydesdale & Yorkshire Bank suggests so because it estimates that UK savers have missed out on £13bn by failing to use their full allowance since ISAs were launched in 1999.

"ISA portfolios have three tax benefits; no more income tax, no capital gains tax and no need to record on a tax return. Even if the savings may seem small, the cumulative effect over time compounds significantly," says Danny Cox of the independent financial adviser (IFA) Hargreaves Lansdown.

An ISA can work well in all aspects of an investor's financial plan, from short-term savings, to rainy-day funds and retirement pots. However, age and circumstance should make a big difference to the role tax-free investments play in any portfolio. One fundamental difference is that many younger savers need more flexibility, while older savers tend to look for more stability.

Cash ISAs are a good way for younger investors to build an emergency savings cushion because these are relatively straightforward and offer easy access with no capital risk. Of the £10,200 allowance, a maximum of £5,100 can be put into a cash ISA from April. This is an annual allowance, so once money has been put into an ISA another cannot be opened during the same year. Savers are, however, free to transfer it directly into another ISA without it affecting their annual allowance.

There has been some movement in the ISA market. A few weeks ago, for example, Birmingham Midshires withdrew its one-year Internet Fixed ISA paying 2.60 per cent and replaced it with a two-year account paying 3.50 per cent. Kent Reliance Building Society has also just launched a range of fixed ISAs with rates ranging from 3.25 per cent up to 4 per cent. The current best buy for an easy-access ISA is First Direct's cash e-ISA paying just 2.75 per cent on deposits from £1. However, the ISA season has yet to really kick off so it may pay to wait. "We are expecting more products to be launched as we move into March," says Rachel Thrussell, of the financial comparison site Money-facts.co.uk. "So if consumers are not in a hurry to open their ISA it may be wise to wait a couple of weeks to find a competitive deal."

As well as relatively poor returns, another problem with cash ISAs is that returns can be quickly eroded by inflation. To combat this, the NS&I's own Index Linked Certificates are another tax-free option and can be a useful part of an investment portfolio. These are 100 per cent secure as they are backed by the Government; you can invest as much as £15,000 per issue and receive guaranteed inflation-proof returns.

"These are an excellent, risk-free method of dealing with the risk posed by inflation, which can have catastrophic consequences," says Joseph Clark, from the IFA No Monkey Business.

Investors should also consider taking on a bit more risk through the equity markets, which offer the greatest growth potential. Equity ISAs let you protect other investments in an ISA wrapper. Options include lower-risk corporate bonds, which can give a high income now, or UK and international equity funds often bought via fund supermarkets such as Fidelity FundsNetwork or Hargreaves Lansdown's Vantage service. "Equity ISAs are designed for medium- to long-term investing, at least five years, but, unlike a pension, you can withdraw money at any time," says Rob Fisher, head of UK personal investments at Fidelity International.

For long-term investing and building a retirement nest egg, statistics show the stock market will beat cash investments over time. But investors should consider scaling down riskier investments as they near the time to use that money.

Friendly societies also offer tax-exempt savings plans, which must run a minimum of 10 years and allow investors to save a maximum of £25 per month or £270 per year. These policies come with automatic life cover, and the proceeds after 10 years are all tax-free. The plans are usually targeted towards smaller savers wanting to build up a small pot. However, they have attracted heavy criticism for the high level of charges which can sometimes dwarf the profits, and most financial advisers recommend using an ISA instead.

Beyond these options, a pension is the biggest tax-free allowance you can get – a £100 contribution costs a basic-rate taxpayer just £80 and a higher-rate taxpayer as little as £60. Starting early is the key because of the year-on-year rolled- up returns. Pension holders can then withdraw up to 25 per cent of their pension as tax-free cash upon retirement.

"Pensions should almost certainly feature in every retirement plan. At retirement, the age-related allowance increases the amount of income that can be received before tax is paid to £9,490. This means a couple can receive up to £19,000 a year tax-free from age 65," says Mr Cox.

Not everyone is impressed by pensions, some experts argue that because investors have to lock their money into a potentially unstable system, ISAs should instead be central to a retirement plan. Mr Clark says: "The loss of capital control, combined with restrictions on allowable income levels, political risk [of legislative change] and uncertainty that the total value of the pension will ever be extracted are disincentives for saving for the long term through this type of vehicle."