Making the most of your ISA allowance

Most savvy savers will have used up their cash ISA allowance to get the best returns on their ISA savings, but many don't consider using the full allowance by making use of Equity ISAs by investing in stocks and shares and earning tax free returns.

Equity ISAs come with a number of advantages over their cash counterparts. To begin with, you can invest your full ISA allowance to invest in them, rather than just £5,100 which is the most you can put into a cash Isa per year. This means that you can invest up to £10,200 every year.

Recent changes to the ISA system mean that as of April 2010, the allowance was increased to £10,200 – half of which can be invested into a cash ISA and up to the full amount into an equity ISA.

Maximising returns

Now comes the question of returns. Cash ISAs pay a predictable rate of interest that can be fixed if you're willing to lock your savings away for a fixed period of time. These ISAs hold no risk, as long as you stick to FSA regulated providers and invest only the current Financial Services Compensation scheme limit.

However, with equity ISAs there is no upper limit to how much you can earn, but these ISAs do come with different levels of risk, depending on the scheme you choose, so in many cases you will also get a regular income.

For example, one of the best performing equity funds over the course of 2009, Neptune Japan Opportunities, produced a return of around 70% for investors over that period, all of which is of course tax free.

It is much more challenging to find the best ISA rates for equity funds than cash ISAs, as the rates of return offered are only a guide to the potential returns offered, so these are never guaranteed. But there are a number of rules that can help you along the way.

The risk factor

Before deciding on an investment, it is a worth thinking about the type of asset that would best suit you. If you have already decided to invest into an equity-based ISA, this shows that you are already willing to add the risk element in order to seek higher returns. But the levels of risk differ between investments, allowing you to choose the amount of risk you wish to take.

Something that's always worth remembering is that you won't gain or lose anything until you sell your shares, and in many cases if your shares lose value, they will recover over time.

Gavin Haynes, of Whitechurch Securities said: "Although the volatility of the stock market can be unsettling, the potential to generate long-term returns is indisputable. Over the past 20 years the FTSE All-Share index has provided a total return (including dividends) of 332pc, equivalent to an annual compound return of 7.6pc."

Be careful when investing in overseas companies, as there is always the chance that exchange rates will fluctuate, sometimes against you. For example, if you buy into an American shares and those shares appreciate by an average of 5%, but the dollar falls by 10% against sterling, the value of your fund will go down.

If you purchase funds that invest in emerging markets, such as China, you could benefit from the successful economic progress, but this can carry greater risks of political instability or unexpected events. It may be safer to invest in global emerging markets funds, as your investment is spread across a group of countries, therefore spreading the risk, although the exchange rate issue still remains.

Diversification is a good method when investing, as each of your funds can take a different approach, so this can help to reduce your overall risk.

Although there is the option to buy funds directly from the companies that run them, this can actually end up costing you more, as fund supermarkets tend to waive the initial charge that fund managers impose which is usually around 5%.