A nasty tale of the dog being wagged

We are approaching the tax-free season. Complete rain forests will be razed to the ground over forthcoming weeks, as the providers of financial products produce promotional material to encourage us to become tax efficient.

We are approaching the tax-free season. Complete rain forests will be razed to the ground over forthcoming weeks, as the providers of financial products produce promotional material to encourage us to become tax efficient.

The message will be simple: if you have not taken full advantage of this tax year's ISA allowance, act now before it is too late. At the close of business on 5 April it will no longer be possible to place up to £7000 in ISAs for the 1999-2000 tax year. Next tax year's ISA allowance will only be £5000.

The message from John Hutton-Attenborough of Woking's independent financial advisers Berry Birch & Noble is clear: "It is essential that people are clear about the tax savings that can be achieved from any investment and that they are sure that the it will be truly beneficial to them."

He also urged potential investors to look carefully at the underlying investment. This is sound advice, for it is all too easy to get swept-up in the whirlwind to beat the deadline that one focuses entirely upon the tax breaks and not on the underlying investment.

Don't let the tail wag the dog. Don't take out any investment purely because of the magical words "tax free". Always ask, "Would I make this investment if the tax breaks were not there?"

If the answer is negative, re-examine your impulse. It is unlikely that any taxpayer would say no to investing in a cash ISA, as this is a basic savings account with a tax-free wrapper.

Only £3000 can be invested this tax year in a cash ISA - next it will only be £1000. If you want to shelter more in an ISA,then you'll likely be offered a stocks and shares ISA.

Although the stockmarket historically has outperformed savings accounts in the long term, shares are not for everyone.

No one should consider investing in the stockmarket unless they have a comfort level of instant access cash savings. The stockmarket is not for the faint-hearted. It will be no comfort to know that your money is sheltered from the taxman if you lay awake at night worrying about the progress of your investment. Financial literature always refers to reducing the risk of investing in the stockmarket by placing funds in unit trusts as these invest in a broad portfolio of shares.

The fact remains though that if the markets plummet, the price of unit trusts does too. Investments in the stockmarket must be viewed as a medium or long-term commitment - that is, for at least five years. If you cannot afford to tie up money for this period, then the stockmarket is not for you.

If you are prepared to invest long term and will not panic when the market takes a plunge, then the stockmarket has the potential to be more rewarding than savings accounts. Having decided whether you want to invest for income or growth, what are the tax breaks you will enjoy with an ISA?

All ISA literature states that the investment is free of income and capital gains tax in the hands of the investor. Reference is also sometimes made to dividends from shares being paid with a 10 per cent tax credit, but the impact of the words is not explained.

On 6 April 1999 advanced corporation tax (ACT) was abolished. Before that date companies paid 20 per cent ACT on qualifying distributions, which included dividends. This was deducted from the gross dividend before payment to shareholders. But the payment was made with a 20 per cent tax credit. Non-taxpayers could reclaim this, and lower and basic rate taxpayers had no further liability to income tax. If the shares were held in PEPs (the forerunner to ISAs), it could be claimed back on behalf of investors.

Now that ACT has gone, 20 per cent is deducted from dividends paid to shareholders. As an interim measure, the dividends are paid with a 10 per cent tax credit. Non-taxpayers not being able to reclaim this, PEP and ISA managers can until 5 April 2004. Reclaiming the tax credit lifts a £9 dividend to £10.

As a rule of thumb, until 5 April 2004, where the underlying investment are shares, non, lower and basic rate taxpayers will only save about £4 a year in income tax for every £1000 they have in an ISA. Charges of 0.4 per cent a year will wipe this out. Higher rate taxpayers will only be at an advantage if the charges are less than one per cent a year. From 6 April 2004 even this small advantage will disappear.

The tax changes have not impacted upon the income paid on corporate bonds and gilts held by non-taxpayers. Taxpayers who have corporate bond PEPs or ISAs are also not affected. These are funds where at least 60 per cent is invested in gilts, bonds or cash.

Corporate bond ISAs generally pay a higher return than savings accounts. Although less risky than investing in shares, they are not risk free. Indeed, as the price of bonds fall when interest rates rise, during the last 12 months investors have lost on average of around 5 per cent of their capital.

In December, the Financial Services Authority (FSA) placed a warning on its website warning investors about high-income products offering higher returns than savings accounts. "These rates can look very attractive, but take care - your capital could be at risk. The higher the rate of return that you are promised, the more likely it is that your money will be put into risky investments, such as high-risk bonds."

So, are ISAs worthwhile? For any taxpayer, the cash option is certainly an excellent opportunity. If you are seeking income, providing you understand the risks, a corporate bond ISA is worth considering. However, do take advice and heed the FSA's warning. If your object is to accumulate capital over time and dips in the market will not cause concern, an ISA where the underlying investment is shares should be your choice. All growth will be free of capital gains tax (CGT) that means you still have your £7100 CGT allowance for making adjustments to your portfolio that is not in its own tax haven.