To get your investment Isa right, you need to pick the right building blocks the funds. But there are other important decisions to make
Over the next six weeks Telegraph Money will be providing readers with plenty of tips and investment ideas as “Isa season” the period before April 6, when savers rush to use their annual tax-free allowance of £15,000 gets into full swing.
We will be picking the brains of the most experienced experts in the business to help savers identify the best Isa funds to suit their needs. But before you start thinking about the actual funds to buy, it’s vital to do some preparation. Read our six-point checklist below, then look out for our fund tips over the coming weeks.
1. Don’t forget cash Isas and pensions
Stocks and shares Isas have an important role to play in the long-term savings plans of millions of people. But they shouldn’t be the only place to put your money.
Everyone should have some “rainy day” money for emergencies, which should be held in savings accounts or cash Isas.
If you are saving for a particular purpose, such as school fees, and will need to use the money in less than five years or so, the stock market is probably not the place to be.
When it comes to saving for longer-term goals, consider whether you should use a combination of Isas and pensions.
Pensions are ideal for those who want to save more than the Isa allowance, or who pay higher-rate income tax. If you belong to a workplace pension scheme, check whether you can increase your contributions and whether your employer will match them (which amounts to free money).
If you do have a workplace or personal pension, bear in mind the investments you have there when you choose what to put in your Isa. Many workplace pensions now invest in “tracker” funds, so your own Isa could be the place to try to get better returns than the market average by picking “actively managed” funds. Our tips over the following weeks will aim to help you do this.
2. Choose the right ‘fund shop’ or stockbroker
Investing in stocks and shares Isas does involve costs. First (Other OTC: FSTC - news) , the fund management company will deduct its fee each year. Minimise this cost by choosing the right fund version (or “share class”). We’ll identify the best ones in our fund-tipping articles.
While it’s possible to buy funds directly from the management company, this is often, counter-intuitively, the more expensive route. It also makes switching to other funds later much more time-consuming. So most investors will set up their Isa with an “investment shop” such as Hargreaves Lansdown (LSE: HL.L - news) or Barclays Stockbrokers. These companies levy their own charges on top.
It’s important to pick the right firm because they do not charge in the same way. Some pocket a percentage of an investor’s total savings, while others charge a flat annual fee.
As a rule of thumb, those that charge a percentage are better for first-time investors, typically with less than £100,000. But savers with larger sums benefit from paying a flat fee.
Fortunately, you don’t need to do the sums for every broker our colour-coded tables identify the cheapest fund shop for the amount you want to invest.
3. Decide what you want the investment to achieve and how long you are investing for
There is no harm in a bit of forward planning. Working out your needs and goals will go a long way towards ensuring that the investments you choose are suitable. This is something that financial advisers stress regularly.
If, for example, you are saving up for school fees, your time horizon is relatively short and you’ll probably be aiming for steady rather than spectacular results. You won’t want to withdraw any income produced by the investments but will reinvest it instead.
Saving for retirement means a longer time horizon but also no need to withdraw income. You’ll be happier with the short-term ups and downs of the market, knowing that they will be well in the past when the time comes to use the money.
But if you are already retired, your focus switches completely to wanting investments that produce a reliable income that should keep pace with inflation. You’ll put more emphasis on avoiding capital losses because there won’t be so much time to recover. And you may want funds that provide monthly or quarterly income.
Your goals and time horizon are vital considerations when it comes to choosing investments. But there is a third factor, risk, which we look at now.
4. Think about your attitude to risk
Two investors with identical goals and time horizons may want to take radically different approaches to investment because they have different attitudes to risk. Some people find the ups and downs of the stock market, and the possibility that their investments could fall in value, extremely unnerving, while others are more confident that, in the end, shares will outperform cash savings, especially if they are held for many years or decades.
Advisers often recommend this rule: if putting money into a particular investment would cause you to lose sleep at night, don’t do it.
Of course, there is no such thing as an investment that carries no risk, but the chances of losing money do vary greatly between different types of funds. So if you think you would lose sleep easily, look towards the more conservative funds and spread the risk by buying a range rather than just one or two.
For most people a balanced investment approach is the most suitable. By picking a range of different types of fund rather than just those that invest in shares, your investments are given ample opportunity to grow, while at the same guarding against serious losses.
Bonds are the main alternative to shares and a portfolio that contains both has historically proved to be resilient over the long term far more so than one invested in shares alone.
How does all this advice on goals, time horizons and attitude to risk translate into actual suggestions about how to construct a portfolio?
Very roughly, a young saver who wants to invest for his or her pension and has a high tolerance for risk could consider putting every penny in funds that own shares, perhaps with plenty of exposure to overseas markets.
But a risk-averse saver in the same circumstances might want 20pc or 30pc of the total in bond funds, to provide a cushion against falls in share prices, and the share element concentrated on the UK market. Twenty years later, the first saver might have 20pc in bonds and the second one might raise the allocation to 50pc.
In retirement, when stability of income is key, you might want about 40pc each in shares and bonds with 20pc in commercial property funds.
Alternatively, there are multi-asset funds, which hold various types of asset. Some are geared towards paying income.
5. Consider consolidating your Isa holdings
Many investors will have taken out stocks and shares Isas in previous years. Now (NYSE: DNOW - news) is a good time to check that they are still suitable for your needs, are performing well and fit in with the ones you are buying this year. But also consider whether you should bring them together with this year’s Isa in one fund shop.
By using one company to handle all your Isa holdings, all of your investments will be in one place, in turn making your investments much easier to monitor.
But bear in mind that the switching process could take several weeks and there is often a transfer charge.
6. A neat trick to cut risk
Avoid the possibility that a market crash on April 6 will knock your Isa off course by investing on a monthly basis throughout the year.
Simply fund your stocks and shares Isa with cash before the April 5 deadline, then set up a monthly investment plan.
This “drip-feeding” discourages investors from trying to second-guess the market and means that you buy more shares when prices are lower.
= Six common Isa questions answered =
Telegraph Money’s postbag frequently receives queries about the Isa rules. Here are the answers to the six most common questions.
How much can I invest in an Isa?
You can save £15,000 for the 2014-15 tax year, which ends on April 5. The Isa allowance will then go up to £15,240.
What are the different types of Isa?
The most popular choice is the cash Isa essentially a savings account where the interest is not taxed. The other option, the stocks and shares Isa, allows a variety of investments to be held, not just shares as the name suggests.
How can I split my Isa allowance? You can put the whole £15,000 in cash, or all of it in shares, or in any combination in between. But you can open only one stocks and shares Isa and one cash Isa in any tax year.
What are the tax breaks on a stocks and shares Isa?
Savers do not pay capital gains tax on profits, but there is a 10pc tax on dividends from UK shares. This is deducted at source, just as with non-Isa holdings. As a result, basic-rate taxpayers will pay the same inside or outside an Isa. Higher-rate taxpayers will, however, net significant tax savings because there is more tax to pay outside an Isa.
I have Isas with different providers. Will they lose the tax benefits if I consolidate all my Isas into one?
If you are unhappy with the rate being paid on a cash Isa or the fees levied on a stocks and shares Isa, you can switch and not lose the tax break. But be sure you contact the new provider to arrange a switch don’t just withdraw the money and reinvest it.
If I don’t use the full allowance can it I roll it over?
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