This piece first appeared in The Daily Telegraph on 2 March 2002
The text here may not be identical to the published text

You needn't run with the bulls

Play safe with a cash ISA

As the weather warms, the ISA man cometh. Mainly he comes to sell us ISAs invested in the stock market. After all, that is where commission is earned. But another sort of ISA is gaining in popularity. You can wrap the tax-free ISA name around what are basically bank or building society savings accounts. And all the interest earned is free of income tax.

Cash ISAs are paying 4.5% a year and finding the best is easy – you just look at the rate and pick the highest. Picking a good stock market based ISA is much more hit and miss. Figures prepared for The Daily Telegraph by Lipper show that the average share-based ISA fell in value by 15% in the tax year 2000/01 so far this tax year the average value had fallen another 7.5%. ISAs invested in bonds have done better. So far this tax year they have returned on average a positive but miserly 2%. Last tax year they managed 6% – less than the best cash ISAs managed that year. Of course, the best shares and bonds ISAs produced far higher returns, but there is no way of picking these in advance.

The message that cash is best is getting through. Out of the £62 billion kept in ISAs in 2000/01, well over half – £34 billion – was kept in cash deposit accounts. And the latest figures show that proportion is growing. Cash also has the advantage that there are no management or upfront charges taken off your money.

The interest on cash ISAs is paid gross and does not even have to be declared on a self-assessment form. That makes them particularly good for the 2.6 million people who pay tax of 40%. But anyone who pays tax at all gets a bonus from the Chancellor by putting their emergency cash or money they are saving up for a holiday into a tax-free ISA account. They are much more flexible than the old TESSAs which had to be left untouched for a five year term. With an ISA you can take money out at any time without losing the tax-free advantage. The only rule is that you cannot put more than £3000 in during the course of a tax year. So if you put in the maximum £3000 on 6 April you can take some or all of it out at any time and all the interest earned so far will be tax-free. You cannot then add any more until the following April 6. However, if you put in £1000 in April, then take it out in September, you can still put in up to another £2000 before the end of the tax-year.

There is one restriction that will affect long-term investors who want to put money into the stock market either through shares or bonds. Cash ISAs are normally taken as a mini-ISA. In other words it is a standalone product – and that is certainly the best way to find the top rates of interest. However, if you take out a cash mini-ISA you are then prevented from taking out a maxi-ISA as well. A maxi-ISA enables you to invest up to £7000 in shares over the tax year – though not in cash. But if you already have a cash mini-ISA you can only take out a shares mini-ISA as well which is restricted to an investment of £3000.

The Government gives special approval to some cash ISAs through its CAT-marking scheme. A CAT ISA has to allow investments of as little as £10, instant access to the money with no penalties for withdrawing or switching and no other charges. Interest rates have to be no more than 2% below bank base rate. All ISAs currently meet that rule – many are paying above base rate. However, a lot of ISAs fail either the £10 rule or the instant access rule and that can be the key to squeezing the last 0.5% on to your rate of interest, though you can find almost as high rates with instant access and low minimum payments.

You should aim for at least 4.5%. As this is tax-free, it is equivalent to 7.5% for a high rate taxpayer and 5.625% for a basic rate taxpayer. Some mini cash ISAs demand all the £3000 at once or certainly a large chunk of it. Others restrict withdrawals or keep your money for months or even years. For these restrictions they pay paltry extra interest. Some boost their headline rates by including a ‘bonus’ for the first six or twelve months.

There are also dangers in moving money from one cash ISA to another to chase higher interest rates. Whenever money is moved, some days interest are lost, on average probably around four. In other words one percent of the annual interest disappears into the clearing system. It will take six months to earn back the money lost moving from an account paying 4.5% to one paying 4.6%.

With cash so popular, perhaps the Chancellor will take the opportunity in his Budget to remove the favoured status of shares and allow us the freedom to invest all our £7000 ISA allowance in cash if we want.

2 March 2002

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