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Isas fall out of favour

Rising returns on cash, stuck markets and loss of tax benefits are bringing a decline in Isas.

In ironic timing, just two weeks after the publication of the Turner report on pension provision and saving in the UK, the Investment Management Association revealed that Isa sales had suffered their first net outflow since their introduction in April 1999.

The net outflow of 23.5m in Isa sales in September followed the lowest recorded inflow of £25m in August.

IMA communication officer Helen Stephenson says there are a number of reasons behind the net outflow. “Returns on cash have been quite favourable as interest rates have risen over the past year. As interest rates increase, investors tend to put less money into equities and more into bank and building society accounts.”

She adds that confidence in stockmarkets is still low, despite positive returns in 2003 and the small growth in UK equities this year.

Stephenson says it is difficult to quantify the effect of the abolition of the 10 per cent dividend tax credit from equities within Isas in April.

In theory, this has made equity funds and shares within Isas less attractive than bond funds. The Government has reduced the dividend tax credit on equities from 20 to 10 per cent and now to zero but bond funds still enjoy a 20 per cent tax credit. For investors with a diversified portfolio, it can be argued they should use their Isa allowance for fixed interest because of the greater tax advantages.

Financial advisers believe the abolition of the tax credit has made Isas less attractive but they stress this is just one of a number of contributory factors. Their attractiveness will be reduced still further in April 2006 with the reduction in the maximum annual limit on Isa investments from £7,000 to £5,000 and cash Isas from £3,000 to £1,000.

Chelsea Financial Services managing director Darius McDermott says the uncertainty surrounding the oil price, US elections and interest rates have not encouraged clients to invest. Clients who are wary of investing have been encouraged to use their Isa allowances each year by the attractive tax benefits but as the tax benefits have declined, clients are less inclined to invest if stockmarkets are performing poorly.

McDermott argues that Isa sales will recover when the stockmarket environment improves but he believes that sales would be helped by restoration of the tax credit. Advisers says many clients do not understand the implications of the abolition of the tax credit but the confusion alone has deterred many from investing.

Hargreaves Lansdown head of research Mark Dampier says two factors led to the net outflows. “After a bear market, some investors start to redeem money when the stockmarket returns close to the levels at which they invested. They decide they do not like the volatility of stockmarkets and are so relieved to have got their money back that they start selling their funds. The abolition of the tax credit has not helped either. It certainly appears that the Government does not really care whether people save or not,” he says.

But Dampier says Isas still have a future because gains are tax-free. He says: “People think they will not have capital gains but if you have accumulated savings of between £100,000 and £200,000, which many people have in an Isa, then you soon break through the personal CGT allowance of £8,200.”

Premier Wealth Management managing director Adrian Shandley says many of his clients have been deterred from investing in Isas because they cannot offset losses against gains elsewhere in their portfolio to reduce their CGT bill.

Another contributory factor to the net outflows, says Shandley, has been greater awareness of the need to plan to mitigate inheritance tax. “You cannot assign Isas to a trust and therefore, on death, there will be a 40 per cent tax bill on an Isa. With the tax advantages of Isas being reduced, clients are withdrawing money to put in trust to cut their IHT exposure.”

But Shandley believes Isas still have a role to play. “Isas will come into their own again when stockmarkets enjoy a sustained recovery and when fixed interest is a good investment again,” he says.

Towry Law investment director Phil Clements says another advantage of Isas is that they do not trigger a chargeable tax event when investors switch between funds. “When investors get older they may want to move some money from equities to bonds but if they do this within an Isa they will not be charged CGT. Investors need to understand the advantages of Isas as part of their overall financial planning,” he says.

Rowan & Co Management head of research Tim Cockerill also believes Isas have a role to play in financial planning. “Investors may see the benefits of Isas in a few years’ time, especially if they are nearing retirement. They may want to take income in five years, which will be tax-free if their assets are in an Isa. Investors may not think they need to be free of CGT but if they invest £7,000 every year, in a few years they will be grateful of having tax-free funds,” he says.

But overall it looks as if market conditions for Isas are likely to remain difficult unless there is a sustained recovery in equities or the Government does a U-turn on the tax benefits.


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