What is an ISA?

What is an ISA?

An Individual Savings Account (ISA) is a savings account that lets you earn interest without paying any income tax, but you are limited to the amount of money you can put into an ISA. You can think of an ISA as a protective box where the money inside is not taxable, and the 2 basic types of ISA are Cash ISAs and Stocks & Shares ISAs.

Basics of an ISA:

An ISA is a tax-free savings account, which allows you to save/invest a limited amount of capital every tax year without paying tax on your returns. The ISA allowance for the 2020/21 tax year is £20,000 (the tax year runs from April 6th – April 5th the following year). This £20,000 can be divided however you like, e.g. you could have £10,000 in your Cash ISA; £4,000 in your Lifetime ISA; and £6,000 in your Stocks & Shares ISA. If you have not used your full ISA allowance for a tax year, you will not be able to carry any allowance over.

To open an ISA, you need to meet the following criteria:

- Be 16 or older (18 for stocks & shares ISA)

- Be a UK resident

- Have a National Insurance number

You can open an ISA online or in store, usually with an initial deposit requirement ranging from £1 - £1,000. You will need to provide all of your details such as; name, address, national insurance number and signature.

For each tax year, you will only be able to pay into one cash ISA, one Stocks & Shares ISA and one innovative finance ISA. This may leave you with multiple ISA accounts with different providers e.g. if you have paid into a different cash ISA every year since the 2008/09 tax year, you would have 9 separate ISA accounts today!

If you would like to change your ISA provider because they offer a better interest rate or other incentives, this is called an ISA transfer-in. If you would like to transfer your ISA, you need to make sure you don’t withdraw the cash to move it into your new account as you will lose its ISA status and you will incur penalties. By transferring an ISA, you do not lose the ISA allowance you have built up in your old account.

Types of ISAs:

The two basics ISA accounts are: Cash ISA and Stocks & Shares ISA. In addition to these regular ISA accounts, there are also some specialist accounts that offer different incentives.

All of the different ISA accounts offered are:

- Cash ISA

- Stocks & Shares ISA

- Lifetime ISA

- Innovative finance ISA

- Junior ISA

What is a Cash ISA?

A cash ISA is simply a tax-free savings account that has a limit on the amount of cash you are allowed to deposit each tax year. There are 3 principle cash ISAs:

- Instant-access Cash ISA: You are allowed to add/withdraw your money at any point. This account usually comes with a variable interest rate.

- Regular Cash ISA: This account usually come with a fixed interest rate as long as you deposit a specified amount of money each month.

- Fixed-rate Cash ISA: This account will require you to ‘lock up’ your money for a fixed time period, and in return you get a high fixed interest rate. The longer period of time you ‘lock away’ your money, the higher the interest rate will be.

The type of account you choose to deposit into really depends on your personal financial situation as well as your financial goals. For example, if you have a stable income that you can rely on, you may want to go for a Fixed-rate ISA because it offers a higher return. However, if you are in a less stable financial situation, it may be better to have an instant access ISA seeing as you may need to withdraw your funds quickly, and you are able to do this without incurring penalties.

If you open a cash ISA with a bank/building society that’s authorised by the Financial Conduct Authority (FCA), you will be protected by the FSCS which guarantees up to £75,000 per person if the bank collapses.

What is a Stocks & Shares ISA?

A Stocks & Shares ISA offers the same tax incentives as a cash ISA; however, they also offer higher potential returns if you are happy to take on some risk.

Whilst a Cash ISA is simply a tax-free savings account, a Stocks & Shares ISA is a tax-free investment account that allows you to grow your money with significantly higher returns. Through your S&S ISA, you will have the opportunity to invest in individual shares; investment funds; investment trusts; corporate bonds; and government bonds. Due to the higher risk of this account, your investment may fluctuate however any dividends or capital gains you receive will be tax-free!

Lifetime ISA

A Lifetime ISA (LISA) allows investors to deposit up to £4,000 annually with a guaranteed 25% return from the UK government. You are able to make a lump sum payment of £4,000, or you can put in monthly payments throughout the tax year to reach that maximum of £4,000. The LISA will return you a maximum of £32,000 profit if you invest the full £4,000 limit annually for 32 years (18-50). The great thing about a LISA is that it is 100% guaranteed you will receive your 25% return due to it being government backed!

If you are thinking this sounds too good to be true, then you are correct! A LISA is primarily aimed at young people looking to get onto the housing ladder, therefore there are a limited number of ways you are allowed to spend your money without receiving penalties. Your only options for spending the money from your LISA are:

- Purchasing your first house (up to £450,000)

- Retirement (over 60’s)

- In the case of terminal illness and have 12 months live

As you can see, this significantly limits your options when taking the money out of your LISA. However, the majority of people will look to buy their first home with the money invested into their LISA, therefore once the house has been bought it becomes a major asset.

What is an Innovative Finance ISA?

Innovative Finance ISAs allow you to earn tax-free interest on peer-to-peer (P2P) lending rather than a Cash ISA or Stocks & Shares ISA.

P2P lending involves you directly lending to borrowers (individuals, businesses, property developer etc), with them paying you back interest in addition to your principal loan. The interest you receive from the borrower is your return, and through an IFISA, you can earn this tax-free.

The interest you receive will depend on the risk category of the investment as well as the amount of time you are willing to have your money ‘locked up’. Putting your money into an IFISA contains a significantly higher risk than simply placing it into a Cash ISA, such as:

- Potential for default

- IFISAs are not FSCS backed and therefore if the company goes bankrupt you may lose all of your money

- Slow cash withdrawal – you may need to wait for months to withdraw funds which could damage your investment significantly.

If you are happy to take on the additional risk of an IFISA, then when looking at investing you should consider a few factors:

- How long you will have your money tied up for

- Your return (the interest)

- Management costs

Once you have taken these (and other) factors into account, you can then make a decision of where to invest your money based on your current financial situation!

Conclusion

An ISA is one of the best investment vehicles for people to use when saving or investing. The tax-free wrapper is an incredible incentive for people looking to effectively grow their money without paying back tax on their returns.

When using an ISA, the main points you need to watch out for are:

- £20,000 annual limit

- Early withdrawals

- Transferring an ISA (make sure you don’t withdraw the money as you will lose its tax-free status)

As long as you are disciplined with your savings and pick the account that is right for your personal situation, ISAs can help with buying your first house, saving for retirement, or growing your ‘rainy day’ fund through a flexible Cash ISA.