Stocks and shares ISAs shorn of a selling point

Simon Hildrey asks if a tax break's death should deter investors

A valuable tax break for individual savings account (ISA) investors will be lost at the end of this tax year when it will no longer be possible to claim a 10 per cent dividend tax credit on equities.

As a result, equity funds and shares held within ISAs will be less attractive than bond funds, which pay fixed interest and still enjoy a 20 per cent tax credit.

Whether Gordon Brown's abolition of the dividend credit affects your choice of ISA will depend on your own circumstances. If you have a large, well-diversified portfolio, it could be worth ensuring that the fixed-interest element is held within an ISA.

If you have £20,000 invested in equity income funds within several ISAs, with an average yield of 3.5 per cent, you will currently be producing an income of £700 a year, calculates Ryan Hughes, investment analyst at independent financial adviser (IFA) Chartwell Investment. But from 6 April, this will fall to £636.

If you had the same cash in corporate bond funds held outside an ISA, you would currently be receiving income of £800; within an ISA, this rises to £1,000. So if you replaced equity income funds with fixed interest, your income would increase from £1,436 to £1,636 after 6 April.

"This difference shouldn't determine whether new ISA investors put money into equity or fixed-interest ISAs but I believe existing ISA investors should see whether they can restructure their portfolio to maximise their tax benefits," says Mr Hughes. "If you hold equity and bond funds, the fixed-interest portion should be within an ISA to take advantage of the tax credit."

On the whole, ISAs remain attractive as you pay no capital gains tax on any profits. And you don't have to declare ISAs on your tax return.

While the abolition of the credit will have a significant impact on income for some investors, that doesn't mean you should rule out equity ISAs this year. "Tax should be a secondary consideration when buying an ISA," advises Patrick Connolly, research and investment manager at IFA John Scott and Partners. "You should pick the right investment for your risk profile and objectives."

Adrian Shandley, managing director of fund manager Premier Wealth Management, warns that investors opting for fixed interest for tax advantages may actually lose out.

"Corporate bonds will underperform equities this year," he predicts. "With interest rates rising and economic growth coming through, equities are likely to outperform, and corporate bond investors will probably receive yield at the expense of capital growth. A 2 per cent rise in interest rates could lead to a 20 per cent decline in capital values."

Jason Hollands, head of strategy at Isis Asset Management, agrees that investors shouldn't disregard equity funds, particularly as the tax benefits of the ISA wrapper last a lifetime. You can put money into equity ISAs now to try to achieve growth. Then later in life, when you want income, you can switch into a bond ISA.

But Mr Hollands has a word of caution for investors buying an equity fund: "Stock markets are likely to be volatile over the next couple of years. Investors should therefore avoid index-tracking funds and choose actively managed ones that can consistently outperform."