New rules on ISAs from April 5th 2008 mean you could get landed with a 20% tax penalty unless you watch out.
There are two changes to the ISA rules that take effect on April 5th:
* Personal Equity Plan (PEP) rules and ISA rules are being aligned. This will affect people with money in both PEPs and maxi-ISAs with the same provider. Providers will merge PEP and maxi-ISA accounts at some point during the year.
* Holders of mini-cash ISAs are allowed to switch them to maxi-ISAs and invest in the wider range of investments including stock market and property funds.
ISAs are getting simpler which is good news
The changes are good in that they simplify things and give you a wider range of options on investing your tax-free ISA cash. But there is a tax sting in the tail you need to watch out for.
Under the old PEP rules, if you held cash in your PEP account, you usually didn’t pay tax on the interest. But under the maxi-ISA rules, the interest you earn on any cash you hold pending investment bears tax at 20%.
You don’t have any choice in the matter - the tax is automatically deducted by the provider. So when a provider merges your PEP and ISA accounts, any interest you earn on cash holdings within that account will bear tax at 20%.
Switching can cause a tax penalty
And if you switch several mini-cash ISAs into a new-style maxi-ISA with the intention of investing the money in shares or funds, then you will also suffer 20% tax on interest earned from the date of the switch.
Financial advisers are keen to encourage people to ‘consolidate’ mini-cash ISAs into maxi-ISAs using fund supermarkets. And if you really want to switch from cash to shares, then this makes sense.
But what doesn’t make sense is to switch from a mini-cash ISAs to the new style maxi-ISA and leave the money on deposit. All you achieve by that is to swap tax-free interest for interest taxed at 20%.
Keep your cash separate
The old distinction between mini-cash ISA and maxi-ISA has officially been abolished. But in practice, most providers will continue to market a cash ISA, with a maximum investment of £3,600 in 2008-09, as a distinct product that earns tax-free interest.
If you invest a larger sum of up to £7,200 in an ISA, then any interest from holding cash on deposit will normally bear tax at 20%. However, some providers will probably offer ISAs where you invest £7,200 and £3,600 goes into a cash ISA earning tax-free interest and £3,600 goes into investment funds.
So it’s up to you to decide how much you want to keep in pure cash ISAs and how much to have in stock market investments within ISAs. Under the new rules, keeping these components separate is the only way to avoid a tax penalty.
Eligible investments within new-style ISAs
-The stock market component:
-Shares listed on UK or overseas markets
-Fixed interest investments listed on stock exchanges
-Funds investing in UK shares, overseas shares, fixed interest and commercial property
-The cash component:
-Deposits at variable or fixed interest rates
