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Understanding stocks & shares ISAs

Category: ISAs
Author: Leanne Macardle
Updated: 06/04/2018

What is a stocks & shares ISA?

A stocks & shares ISA, otherwise known as an equity ISA or investment ISA, is a way to invest in a wide range of funds and other stock market investments whilst retaining the tax-efficient element of a traditional cash ISA, with the money held in such an account being exempt from income and capital gains tax.

However, unlike cash ISAs, where savings are held in a bank or building society account, with the stocks & shares version you actively invest your money across your choice of funds in the stock market or directly into company shares. The majority of such accounts use collective investment funds, such as Unit Trusts or Open Ended Investment Companies (OEICs).

While you can hold individual company shares in an equity ISA, a fund-based ISA will be run by an expert fund manager who will pool investors' money and decide which companies and assets to invest in. The type of investments they'll make will depend on the aims and objectives of the specific fund (i.e. whether it's for income or growth – see below), and investors can either receive a form of income during the term of their investment or wait until they cash in the investment.

What's the difference between a cash ISA and an equity ISA?

The key difference between cash ISAs and equity ISAs is that the cash version holds onto your cash and pays interest, while an equity ISA actively invests your money into different external funds or company shares for the potential of bigger returns. The returns come from a combination of an increase in the value of the fund due to increased share prices, and dividend payments into the fund from the companies which the fund invests in.

A cash ISA is essentially the same as a traditional savings account without any tax implications. With this form of tax-free saving, your deposits are held in a bank or building society account and are currently covered by the Financial Services Compensation Scheme (FSCS), at up to a maximum of £85,000 per person per individual banking licence, and your capital is guaranteed.

An equity ISA, however, is not a savings account and should be viewed more as an investment product. It's a higher risk home for your money and there's a chance you could lose some or all of your initial investment, and there are also different rules regarding FSCS protection, with investors being currently covered for up to £50,000 instead of £85,000.

Buying an equity ISA – before you get started

Equity ISAs are more complex than cash versions. There are a number of different products you can choose from and different funds you can invest in, but by asking yourself the following simple questions, the process of making a decision becomes more straightforward:

  • Can I afford to take a longer-term view towards investing? In other words, you shouldn't need to take money out of your ISA to buy everyday items or for emergencies.
  • What level of risk am I willing to take? People who can afford to lose some of their money and have the longest view on investing are generally willing to invest in riskier funds.
  • What am I looking for from my ISA? Some people want their ISA to provide them with additional income, while others simply look for the value of their ISA to grow.

Once you have answered these questions, it's time to think about the funds that are right for you.

What is your goal?

Generally, investors have one of two goals – either to generate a regular income to supplement other payments (such as a pension), or to build a large value of investments for a particular use, i.e. to buy a dream holiday or send their child/grandchild to university.

Generating income can be achieved by investing in income funds (denoted by the term 'Inc'). The fund manager will usually invest in assets that provide interest or dividends which will then be passed on to you as an income payment from the fund, or alternatively you can have this income paid back into your investment to buy more of that fund.

Generating growth can be achieved by investing in growth funds (also known as accumulation funds, denoted by the term 'Acc'). The fund manager will usually invest in assets that are expected to increase in value, perhaps through an increase in a company's share price or an increase in the price of commodities.

Once you have an idea of the sort of fund that will help you achieve your goals, you can start to research suitable funds.

How much can I invest?

In the year 2018/19 your ISA allowance is £20,000, which you can either split between a cash ISA, the new Innovative Finance ISA and an equity ISA in any way you choose, or invest fully into an equity ISA (or one of the others). You can now invest up to £4,000 of your annual allowance in a Lifetime ISA, and withdraw and replace funds you have invested in an ISA without the replacement funds being counted as part of your ISA allowance. However, this flexibility may not be appropriate for an equity ISA, as money invested should be considered a longer-term investment.

Advantages and disadvantages of an equity ISA

Investors choose fund-based investment ISAs for a number of reasons, with a few of their advantages being:

The potential for better returns – investments offer the chance to secure better returns, with the outcome being dependent on the value of your assets rather than interest rates.

The reduced risk when compared with trading individual stocks. With fund-based equity ISAs you're essentially still trading in the stock market, but unlike the direct route you're not buying shares of individual companies. By diversifying your investments, you're reducing risk while still getting the potential for better returns.

An alternative to poor interest rates. A lot of investors have found their income seriously affected by the record low interest rates of the last few years. Equity ISAs can therefore be a viable alternative.

The simplicity and convenience. Because you're putting your investments in the hands of a fund manager, you can benefit from their level of expertise while removing the complexity of direct investments. There's no need to constantly monitor the market or be involved in the day-to-day management of your money – just choose the fund that suits your needs and they'll do the rest. However, you should make sure your funds are performing well and continue to meet your investment objectives.

Of course, there are drawbacks to consider as well, with the disadvantages of this type of investment being:

The increased risk. The very fact that your money is actively working for you adds a certain amount of risk to the investment. Unlike with fixed rate cash ISAs there's no guarantee on the level of return you're going to get, and investors risk losing some or all of their initial investment. Anyone not comfortable with that and who wants to take the least amount of risk should consider a cash ISA instead.

The long-term view. Equity ISAs are only suitable if you're willing to commit your money to an account for the longer term. Short-term investments won't have the same effect as long-term investing offers the best scenario for growth, and while most funds can be sold at relatively short notice, this type of account won't be good for those who might need to dip into their savings.

The fund charges. Equity ISAs may be exempt from income and capital gains tax, but remember that these ISAs will usually charge various fees, such as an initial charge, annual management charge (AMC) or even performance-related charges, so always check the small print to see if the particular account is worth it.

Is an equity ISA right for me?

Yes, if:

  • You have a medium to long-term view on your savings
  • You are happy to take a degree of risk in search of the potential for greater returns

But not if:

  • You have a short-term view on your savings
  • You want to take the least amount of risk with your money

Understand the risks

Any investment comes with an element of risk, particularly those with the prospect of higher returns, and it's important for any potential investor to understand them.

Over time there could well be fluctuations in the value of an investment, with the total value and any income generated capable of going down as well as up, and as such in a volatile market some investors may get back less than they put in. Past performance should never be seen as an indicator of future returns.

Disclaimer: This is a basic guide to stocks & shares ISAs. It does not cover every circumstance and nor is it intended to be a source of advice. This information is aimed at customers within the UK. Tax treatment depends on your individual circumstances and may be subject to change. Moneyfacts will not be liable for any loss arising from your use or reliance on this information. If you are in any doubt, Moneyfacts recommends you obtain independent financial advice.

Disclaimer: This information is intended solely to provide guidance and is not financial advice. Moneyfacts will not be liable for any loss arising from your use or reliance on this information. If you are in any doubt, Moneyfacts recommends you obtain independent financial advice.