Pick the right Isa for you

Are Isas a good investment? Over the next few weeks, you will certainly see financial services companies spend big on marketing and advertising in an attempt to persuade you to stick your money in one. After all, the tax year ends on 5 April – after that day, this year’s Isa allowance is gone for good.

Here’s the thing though – it’s a trick question. Isas, or individual savings accounts, to give them their full name, aren’t actually an investment at all. Rather they are wrappers you can use to shelter a broad range of genuine investments from tax on income and profits.

Watch out for the tax tail

The distinction is more important than it first appears. The allure of an Isa is the tax breaks it offers. But to get those tax breaks, you have to make investments inside your Isa – and if those investments are not right for you, there’s a real danger that you’ll lose more than you got from the tax saving.

Investment old hands put that more succinctly. Never let the tax tail wag the investment dog, they counsel. In other words, every investment you make has to be right for you; if there’s a tax perk available on top, so much the better, but don’t invest simply to get that perk.

In the annual rush to take advantage of Isa allowances, this wise advice is often overlooked. You can make £20,000 of investments inside an Isa each tax year, but any unused allowance can’t be carried over from one year to the next. So it often feels tempting to scramble to beat the deadline. And investment product providers add to the confusion, often selling their wares with the wrapper attached, so that it feels as if you’re investing in an Isa, rather than what sits inside.

Take your time

None of which is to say you should steer clear of Isas. Quite the opposite in fact – the value of tax-free income and capital gains can be very significant, particularly over the longer term. Research released last month found more than 2,000 Britons have now built up savings within their Isas of at least £1m – the tax bill on those sums could be very significant if held outside the wrapper.

What you do need to do is to think very carefully about those underlying investments. What is your reason for saving – do you have a specific purpose in mind, or are you simply trying to build as large a nest egg as possible, and when will you need to access your cash? What is your appetite to risk – are you prepared to stomach falls in the value of your savings as well as increases, even if the losses are on paper only? What other investments do you already hold – and what might it be appropriate to add this year to ensure you’re spreading risk sensibly?

The answers to these questions (and plenty more) will lead people in very different directions. If you may need to withdraw savings in the next year or two, or you’re highly risk-averse, holding stock market investments within your Isa may not be appropriate. If you’ve used previous years’ Isa allowances to invest in UK stock market funds, maybe now is the time to add some international holdings.

The choice is yours

Remember, the choice of investments you may make within an Isa is very broad. With a cash Isa, for example, you’re simply opening a bank or building savings account with the protections that Isas offer. Your money won’t fall in value, though inflation may erode its purchasing power.

A stocks and shares Isa, by contrast, gives you exposure to the ups and downs of financial markets – including the stock market, but also other areas including bonds and other assets, if that’s what you want. And here too, there’s plenty of choice: you can choose individual investments for yourself, or you can invest through a professionally-managed fund such as an investment company, which offers the expertise of a fund manager and diversification since you’ll invest in a spread of holdings alongside other investors in the fund.

If all this sounds simplistic, the truth is that many of us don’t get it right. We leave money in cash savings, losing value as inflation attacks it, even though we could invest it more profitably over the longer term. Or we have a disparate collection of investment funds, because we allow ourselves to be swayed by marketing campaigns, rather than thinking about what actually makes sense for us.

In short, there is no one-size-fits-all approach to Isas that works for everyone. But the key is to understand what you’re doing here. By all means use your Isa allowance before it’s too late this year, but make sure you’re choosing the investments within it for the right reasons.