Surviving in the ISA jungle

Individual savings accounts (ISAs) are more complex than they need to be, but if you don' t take advantage of them you could miss a valuable chance to invest up to £7,000 free of income and capital gains tax.

Individual savings accounts (ISAs) are more complex than they need to be, but if you don' t take advantage of them you could miss a valuable chance to invest up to £7,000 free of income and capital gains tax.

ISAs were brought in last April to replace personal equity plans (PEPs) and tax-exempt special savings accounts (Tessas). They were heralded as a more accessible introduction to tax-free saving for inexperienced and less well-off investors. But the attempt to be all things to all investors brought complicated regulations and restrictions which catch out unwary individuals.

Provided you're 18 or over and resident in the UK for tax purposes, you can open an individual savings account. Soon, the total maximum allowance will be £5,000 per person, but for this first year (until 5 April), Gordon Brown, the Chancellor, has boosted that to £7,000.

There's a broad choice. Three ISA components are available - cash, stocks and shares, and life assurance - and they can be used in two ways. Either you can put the lot into one plan, as a so-called maxi-ISA, or you can split the different components between different plan managers by taking up to three mini-ISAs.

In the same year, you cannot open both a maxi- and a mini-ISA, otherwise your later investment will be deemed void by the Inland Revenue.

Maxis

Who should choose a maxi Isa? If you're keen to get maximum exposure to the global stock market, this is for you. A maxi- ISA will allow you to put up to the full £7,000 into share-based investments in any recognised stock exchanges, including equities and bonds, unit and investment trusts and OEICs.

Most maxi-ISAs include a cash component, in which, this tax year, you can hold up to £3,000 in cash or national savings. A few also offer an insurance component allowing you to hold up to £1,000 as a life policy. (When the total allowance is reduced to £5,000 after April, the cash element will be slashed to a maximum £1,000 holding.)

Because stock markets, though relatively risky, are where the greatest long-term returns are to be found, a maxi-ISA would be most effectively used for a pure stock-market investment - say, a unit trust - of up to £7,000, depending on how much you can afford to tie up for the next three to five years.

If you might need to draw on your money in the coming year or so, you could reduce the unit trust element by a thousand or two and hold that as cash.

The drawback with a maxi- ISA is that you are unlikely to get an attractive interest rate for your cash from a fund manager. But you can move funds between different components within a maxi-ISA. If you found your potential liquidity problem had eased, you could switch some or all of your cash holding into the unit trust element.

Minis

What about mini-ISAs? They allow you to invest a maximum of £3,000 into stocks and shares, £3,000 into cash and £1,000 into life assurance. Mini-ISAs make sense for the more risk-averse, who don't want to put more than £3,000 into the stock market or who feel more comfortable with a substantial cash holding.

The advantage is that you can hunt the best interest rate for your cash from a separate cash ISA manager (top rates include 7 per cent from Smile and the Principality building society, and 7.05 per cent from Leeds and Holbeck building society).

There are disadvantages. First, you have significantly less flexibility in how you allocate your assets - you cannot simply "scoop up" an unused allowance for one component and use it for another. Thus, even if you put just £1 into a life assurance mini-ISA and £1 into a cash mini-ISA, you have only £3,000 available to channel into the stocks and shares element. (If you'd done the same within a maxi-ISA, you would still have £6,998 to put into your stock market investment.)

Second, once you've committed yourself to a mini-ISA, you cannot switch or transform it to a maxi you' re stuck with minis only for that tax year.

But do not open a mini cash or insurance ISA unless you' re absolutely sure you don't intend to invest more than £3,000 in the stock market element.

The widespread fear in the industry is that many investors have fallen into that trap - they opened a cash Isa when those attractive headline rates were being promoted, but are now thinking about sticking several thousand into a unit or investment trust (probably one of the technology funds so heavily touted by many financial advisers). Up to £3,000 is fine, but if you over-invest you run the risk of invalidating the tax-free status of the whole investment when the Revenue finds out.

Although the insurance element was originally seen as a relatively safe option for small investors new to the stock market, in practice, few Isa managers have bothered to develop an insurance Isa; there are only about a dozen on the market.

Limited choice and the relatively high charges associated with insurance policies mean even cautious and inexperienced investors are better off sticking to low-risk stock market investments such as corporate bond funds or protected equity funds. Drip-feeding via regular monthly payments can also help reduce the risk if the market suddenly plummets.

In addition to the £7,000 main Isa allowance, holders of maturing Tessas can open a special "Tessa-only" ISA into which they roll over the Tessa capital (not the interest earned). That capital earns a good rate of tax-free interest indefinitely (unless it's a term Tessa). Tessa capital can also be put into a cash ISA. This does not count as part of your annual allowance.

CAT standards

ISA investing has been further complicated by the Government's quality-control attempts to cover Charges, Access and Terms, the CAT standards. These don't say anything about the quality of the ISA manager, past performance or suitability for particular investors. They are simply an at-a-glance seal of approval indicating "a fair and reasonable deal".

A CAT-marked cash Isa will have no one-off or regular charges attached; it will permit minimum transactions of no more than £10, arrange withdrawals within seven days and pay interest of no more than 2 per cent below the base rate. A CAT-marked shares ISA must levy no initial charges and annual charges of no more than 1 per cent, permit minimum lump sums of £500 or less and monthly payments of £50 or less, and be invested at least 50 per cent in EU-listed stocks.

These are stringent criteria, and many providers do not meet them. Most CAT-marked unit trusts are index trackers or corporate bond funds, because they are the only ones that can be run so cheaply. Good active fund management teams are expensive to maintain. Again, many funds do not qualify because they invest primarily in stock markets beyond the EU. And perfectly above-board cash ISAs may not be CAT-marked because they trade off an attractive interest rate against a longer notice period.

CAT marks are not very illuminating. Don't be distracted by them, because the difference between top and bottom performers is greater than the few percentage points' difference in charges. (To put that into perspective, £1,000 invested in the top-performing UK All Companies fund over five years to 1 January would have grown to £3,600. A thousand invested in the worst performer in that sector would be £1,500.)