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SPECIAL REPORT: ISAs. Samantha Downes looks at the changes which enable cash Isas to be switched into stocks and shares.

Changes to the Isa regime are expected to increase interest in stockmarket-linked versions but investors will still need all the help they can get in making an appropriate choice.
From April, any investor who has saved into a cash Isa can transfer all or part of their balance into an equity version of the tax-free investment.

Jason Britton, fund manager of the £11.7m T Bailey cautious managed fund, says diligent investors who have put their total £3,000 allowance each year into a cash Isa since they were introduced in 1999 would have £24,000 plus around £4,000 in accumulated interest.

He says: “These investors may look on this as their cash portfolio but there will be many who will be tempted to take some risks.”

Britton believes a cautious managed fund may be the answer because they limit equity exposure to 60 per cent. He says the Investment Management Association’s cautious managed sector has generated significantly greater returns than cash.
“It diversifies risk across various sectors including equities, which, of course, are limited to a maximum of 60 per cent, fixed interest, cash and, in some cases, property too,” he says.

Britton also points out that fund of funds in this sector have outperformed the sector average by 4.6 per cent over the three years to the end of 2006.

He says: “Given that investors with significant cash Isa balances are likely to be cautious in nature, we would predict that the IMA cautious managed sector could be one of the main beneficiaries of transfers from cash Isas.”

But Hargreaves Lansdown research director Mark Dampier says that most investors in their 20s, 30s or early 40s could afford to take risks with their Isa investment. He says: “If someone wants to invest in a cash Isa, the chances are they will consider that as being part of a cash portfolio and will not want to touch it.

He recommends starting new Isa investors with a monthly savings plan, ideally on a platform.

Dampier says: “On a plat-form, you have the option of saving a minimum of £50 a month and you can start with one Isa and then add more as you earn more. If you end up with four different Isas you end up with eight bits of paper, with a platform you get one.”

Instead of immediately diversifying, Dampier suggests starting investors off with a UK equity fund.
He says: “For example, they could invest a lump sum of £1,000, or £50 a month, into a fund such as Jupiter equity growth.”

When they are comfortable with that, they could consider riskier sectors. “When they get a pay rise, they might want to consider an emerging market fund too, but at the same time start adding more to their UK equity Isa, say, up to £60 or £70 a month,” says Dampier.

He adds that investors who want diversity could use a fund of funds such as M&G global leaders rather than having several different funds. “Even someone with £100,000 to invest should really have no more than 20 holdings, otherwise they are overdoing it. I spoke to someone recently with 60 holdings. Even some of the best fund of funds have no more than 30 holdings within them.”

Peter Hicks, head of Fidelity’s IFA channel, also believes that over-diversif-ication can end up undoing any potential gains.

He says: “When people diversify, they are trying to diversify risk but what they may end up doing is diversifying away return.”

Hicks believes that using a platform is a good option. He says: “If people do want to switch Isas, they can do so at a much reduced cost. At Funds Network, we charge 0.25 per cent.”

For investors wanting a UK equity Isa but wary about risk as well as cost, index-trackers are an option, says Legal & General wealth management director Claire Stracey.
She says: “They outperform most active funds over the longer term so you do not have to keep moving it around. I know that we have banged on about this forever but it seems to be true more than ever as equity stock volatility appears higher than ever.”

As an Isa season incentive, L&G is offering cash back to investors who put a lump sum of £4,000 into its index-tracking Isa before April 30, 2007. Stracey says: “The cashback is a refund of the annual charge so, as there are no initial or exit charges with L&G index- tracking Isas, I guess that makes them almost free.”

To be eligible for the rebate, clients must not cash in part or all of their investment before December 2007 and should hold the investment in the same trust without switching.
Isa investors need to be aware a stockmarket-linked investment is a medium to long-term investment – “at least five years,” says Stracey.

Britton believes that Isas can be as tax-efficient as pensions and better suited for some investors. A basic taxpayer who expects to move into the 40 per cent tax bracket should always consider putting money into Isas.

Steve Potter, from The Pensions Partnership, says investors who save in an Isa when they are basic-rate taxpayers and then switch the money into a pension fund when they move into the higher-rate bracket could be thousands of pounds better off.

For example, a basic rate taxpayer investing £7,000 into a pension would have this grossed up by 22 per cent to £8,974. After five years, assuming a rise of 5 per cent a year, the pension would be worth £11,454.

A basic-rate taxpayer who invests £7,000 into an Isa, then switches to a pension fund when paying 40 per cent tax would see five years of 5 per cent growth at £8,934 but, by switching to a pension fund will get that grossed up by 22 per cent to £11,454. You then apply for higher-rate tax relief on the grossed-up contribution. At 18 per cent additional relief, this comes to £2,062.

Potter says: “You are instantly over £2,000 better off but this is just the start.”

You can invest this extra £2,061 back into the pension and gain another 22 per cent instantly turning it to £2,643. You then claim tax relief on the other 18 per cent of this £2,643, which is £476 – which you can then invest again in a pension fund taking it to £610. And the year after that you can claim 18 per cent on the £610 (£110) and keep on doing this till eventually it dwindles to pennies.

“It takes discipline to keep recycling but it’s worth it,” says Potter. “After just two years, the basic-rate taxpayer in our example who invested one year’s allowance in an Isa and then transferred it five years later when they were a higher-rate taxpayer is £3,363 better off – generated entirely through tax relief.”

The main danger with this strategy, says Potter, is if the Government abolishes higher-rate relief on pension contributions but even in that event, if basic-rate relief remains, the position should be neutral.

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