Choosing an ISA

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Looking to build up a savings nest egg?

If you can spare anything from £1 to £7,000, an ISA (Individual Savings Account) could be the ideal place for your money. For many of us, it's the first rung on the savings ladder.

The great advantage of an ISA is that it's tax-free. Take 10 minutes to find out how ISAs work and figure out which one is for you.

Before you begin: Think about how you want to save
Sit down and work out the following:
- Do you have a one-off lump sum to invest?
- Do you want to save regularly each month? How much?
- Do you want instant access to your money?
- How do you feel about risk?

Step 1: Understand the ISA concept
An ISA isn't actually a financial product in its own right. It's a tax-free scheme (often referred to as a tax-free 'wrapper'), which you can use to hold cash or stocks and shares. There are two kinds of ISA, and two kinds of 'wrapper'.

Cash ISAs are straightforward savings accounts available from banks and building societies. The interest you receive is tax-free.

Stocks and shares ISAs are widely available too. With these, the money you save is invested in stocks and shares and so is linked to the performance of the stock market. An easy way to do this is to join a collective investment such as a unit trust, where a fund manager picks a range of shares to invest in on your behalf.

There are two types of ISA wrapper: a mini ISA and a maxi ISA. A mini ISA can be either cash or stocks and shares, while a maxi ISA must contain stocks and shares (with the option of some cash too).

You can hold two mini ISAs - one cash, one stocks and shares - from two different specialist providers in the same tax year, but with a maxi ISA all the elements have to come from the same provider. You can't open a mini and a maxi ISA in the same tax year.

Step 2: Know the ISA limits
The interest you receive from an ISA is free from income tax (and, in the case of stocks and shares ISAs, free from capital gains tax too). But there are limits on how much you can put into them each year.

You can invest up to £7,000 in a stocks and shares maxi ISA. Alternatively, you can split your £7,000 allowance across two mini ISAs, with £3,000 in a cash ISA and £4,000 in a separate shares ISA.

If you want to invest the maximum £7,000 in shares, then you have to go for a maxi ISA.

Step 3: Balance risks and opportunities
Cash ISAs are just like any other savings account (with the added tax-free interest bonus); the actual money you put in (the capital) is always protected.

But it's worth shopping around to find out which pay the best interest rates: for instance, you may be able to get a higher rate if you're prepared to give notice of withdrawing cash or to tie up your money for a longer period.

ISAs involving stocks and shares are like all stock market based investments - they can go down in value as well as up. On the other hand, greater risk usually means greater potential reward (eventually). Stocks and shares ISAs should be seen as a medium-to-long-term investment (at least five years).

Step 4: Stick to the rules
ISAs come with a few rules. You are only entitled to one ISA each tax year, and you can't take out a mini and a maxi ISA in the same tax year.

If you put the maximum amount into a cash ISA and later make a withdrawal, you can't then put the money back in the same tax year.

You must be at least 16 years old to take out a cash ISA and 18 for a stocks and shares ISA.

Step 5: How do you want to pay in?
You can pay into your ISA in a lump sum or, with many mini cash and maxi ISAs, make monthly contributions, perhaps timed to coincide with your pay day.

You don't have to hold the account for any set length of time and many ISAs let you withdraw your money without losing tax benefits. Check first if this is likely to be important to you.

Step 6: Make the most of your tax allowance
The Government has promised that the annual £7,000 limit will stay until at least 2010.

The earlier in the tax year that you start your ISA, the longer your money will have to work for you.

Step 7: Seek independent advice
There are hundreds of ISA products on offer from a range of financial institutions, from high street banks and building societies to investment companies.

Picking a simple cash ISA is easy enough; check out the latest interest rates in the weekend newspapers or on the internet. But if you want to invest in stocks and shares then it's worth considering getting independent financial advice.

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