Why an ISA makes a handy tax shelter

Keeping your savings and investments out of the tax collector's reach can boost your returns by around a quarter or more. So whether you opt to put your money in a simple savings account or in the shares of internet companies, it makes sense to do it under the tax shelter of an Individual Savings Account (ISA).

Keeping your savings and investments out of the tax collector's reach can boost your returns by around a quarter or more. So whether you opt to put your money in a simple savings account or in the shares of internet companies, it makes sense to do it under the tax shelter of an Individual Savings Account (ISA).

ISAs were introduced in April 1999 by the Labour Government, replacing the Tories' system of PEPs and TESSAs. ISAs are very similar to their predecessors. They are not investments in themselves, but act as a wrapper for investments which keeps their returns and growth free of income and capital gains tax.

They can be used to hold cash investments, such as an instant access savings account, stocks and shares in the form of investment funds or individual shareholdings, and insurance-based investments.

There are annual limits on how much any one person can put into an ISA.

When ISAs were first designed, the limits were higher for the first year of the scheme, but the Government has since decided to stick with these higher allowances at least until 2006.

Up to £7,000 can be invested in ISAs in a tax year, with a maximum of £3,000 of this in cash and £1,000 in insurance. Before taking out an ISA, you have to decide whether the "mini" or "maxi" version of the wrapper suits you best. You can either take out a mini ISA for each element or investment type, or you can start with one maxi ISA which is usually capable of containing cash, equities and insurance.

The advantage of choosing mini ISAs is that this allows you to shop around for the best provider in each category. For example the best-paying mini cash ISAs on the market pay interest at rates of more than seven per cent at the moment, but with a maxi ISA only b2 and First Direct pay a rate this high for smaller sums.

However, if you do use mini ISAs, you are limited to £3,000 in stocks and shares investments per year. With a maxi ISA, as long as you forgo the cash and insurance parts of the investment, you can shelter up to the full ISA allowance or £7,000 in stocks and shares. So if you are largely interested in stock market investment, a maxi ISA makes the most of this particular tax break.

Some advisers argue that the tax breaks for stocks and shares ISAs are not necessarily worth having. After all, most unit trusts, investment trusts and open-ended investment companies (OEICs) - the funds contained within equity ISAs - produce capital growth rather than income. And as the individual only has to pay CGT on gains above £7,200 this tax year, the investment would have to be very large to exceed this.

But if you hold your ISAs until retirement, for example, you may then want to switch the investments to income-prod-ucing vehicles, and as long as they remained within an ISA, any income would be free of income tax. This is more than you can say for pension income.

There is one further type of ISA which is designed for savers who have maturing TESSAs. TESSAs, which were introduced in 1991, are deposit-based investments with strict rules and investment limits and a life of five years. Follow-on TESSAs were introduced in 1996. Savers could start a new TESSA up to April 1998 when ISAs were introduced. Many TESSA savers now have funds maturing in these accounts.

If you want to keep the capital free of tax in the future and do not want to use up your standard ISA allowance, you can put the money into a TESSA-only ISA. This will not affect your £7,000 annual ISA allowance. However, you cannot put interest earned in your TESSA into a TESSA-only ISA.

You have six months after your TESSA matures to move the funds to a TESSA-only ISA, and after this you lose the entitlement to this extra tax-free savings allowance.

You can shop around for a TESSA-only ISA, and do not have to stick with your existing provider. The provider has to issue you with a "TESSA maturity certificate" to enable you to re-invest the funds elsewhere.