You might think that ISAs (individual savings accounts) are complicated. But they’re actually quite easy to understand. Plus, they can make your money work harder – always a good thing!
In this guide, we explain what an ISA is and then run through some of your options. The type of ISA you choose will depend on your savings goals and risk tolerance.
What Is An ISA?
An ISA is a special type of savings account that shelters you from capital gains tax.
Usually, when you invest in assets that generate a return (such as stocks and shares), you’ll have to pay capital gains tax on any appreciation (above a certain threshold). That means you could end up with some hefty tax bills in the future, just for withdrawing your money.
ISAs, however, protect against this. With them, you can squirrel away a predefined sum every year tax-free, allowing you to relax, knowing that no matter how large your capital gains, you’ll never have to pay money to the government.
How Do You Invest In An ISA?
For the tax year running from 6 April 2021 to 5 April 2022, you’re allowed to deposit a maximum of £20,000 into your tax-free cash or stocks & shares ISA. It doesn’t matter how much that money grows in the future or how long you keep it, you’ll never pay any capital gains on your returns.
So, for instance, if you invest in company shares that appreciate by 150 percent over the next fifteen years, your account will be worth £50,000 at the end of the period. Normally, if you withdrew the entire amount, you’d incur capital gains tax on the £30,000 profit. But in an ISA, there’s no tax to pay, regardless of the size of the gains.
However, there are strict rules around when you can put your money into ISAs. If you miss the allowance window, it’s gone forever. You can’t get it back. So, for example, if you fail to fill your allowance, you can’t backfill it in subsequent years.
In the short term, returns in ISA accounts are usually modest. But, depending on how you invest, the long-term gains can be considerable. Interest in both cash and stock & shares accounts compounds over time, leading to substantial returns over the course of a decade or more.
What Different Types Of ISAs Are Available?
Financial institutions and stock brokers provide access to various types of ISA. Below we discuss them individually.
Banks and building societies provide cash ISAs. These work similarly to regular savings accounts. You deposit money into them from your checking account and, in return, the bank provides an interest payment (usually paid monthly).
You can deposit a limited sum of money into the account (£20,000 for the 2021 – 2022 tax year). And you can withdraw funds at any time you like. However, if you choose to withdraw, it does not add back to your remaining allowance.
Some banks offer fixed cash ISAs. These offer a higher rate of interest, but you agree not to withdraw funds for a specified period. If you do, you may have to pay an interest penalty.
There are also so-called Help to Buy ISAs – something that the government introduced to make it easier for young buyers to get on the housing ladder. These ISAs are no longer available. But in the past, they provided people with a way to save for homes, with contributions topped up by the government.
If you have a cash ISA in a financial institution, then the government will protect all deposits up to £85,000 under the Financial Services Compensation Scheme. If there is another financial crisis, any money saved above that threshold is potentially at risk.
Stocks & Shares ISAs
When you invest in a cash ISA, you hand over capital to financial institutions who then invest in other return-generating assets, like property. But with a stocks & shares ISA, you can cut out the middleman and invest directly yourself.
Stocks & shares ISAs allow you to use your allowance (£20,000 for the 2021-2022 tax year) to invest in financial instruments. You can put your money into:
- Equities: Stocks and shares the provide you with dividends from company profits (often automatically reinvested)
- Bonds: Loans to various organisations and institutions
- Commodities: Items including oil, copper, coffee and gold
- ETFs: Diversified securities that link to a range of underlying assets, including stocks, shares, bonds, property and commodities
When you invest your money via a stocks & shares ISA, your capital is at risk. That means that there is a chance that your money could go up as well as down.
Many investors lose money when they invest in stocks & shares ISAs because they adopt risky strategies. So if you haven’t invested before, you may want to discuss your financial plan with a wealth manager.
When investing in a stocks & shares ISA, you won’t pay any tax on gains, but you will pay fees. These include:
- Basic broker charges: Most brokers will charge an ongoing fee for keeping an account with them
- Management fees: If you buy certain types of securities, such as ETFs, you may have to pay a management fee – usually between 0.1 and 0.5 percent.
- Trading fees: Brokers will also charge a fee for each trade. This might be a fixed amount, say £8, or a percentage of the trade, say 1%.
- Transfer fees: Some platforms charge money for moving cash funds from your ISA account into a different account, such as a regular share dealing account.
Please note that your stocks & shares ISA savings aren’t protected from losses under the Financial Services Compensation Scheme. You must accept the risks (and rewards) of the market.
The government introduced lifetime ISAs in 2017 as a way to help first-time home buyers and retirees. However, the rules are different from the options discussed so far.
Lifetime ISAs have a £4,000 limit. For every pound you add to your account, the state will add a 25 percent bonus. So, for example, if you save £2,000, the government will add £500 for you.
Lifetime ISAs allow you to invest in both stocks & shares and cash:
- Cash lifetime ISAs are usually preferred by people saving for home deposits
- Stocks & shares ISAs are better for those looking to invest longer term, say, for retirement
Additional rules include:
- You can only open a lifetime ISA if you are aged 18 to 39. After you reach 40, you can no longer open one. However, you can continue paying into your account until you reach 50.
- You can only withdraw money if you are a first-time home buyer or you’re over the age of 60. If you take money out at any other time, you’ll lose the government bonus.
Innovative Finance ISAs
Investing in an Innovative Finance ISA (IFISA) allows you to lend to other people tax-free. You give businesses and individuals the capital they need, and, in return, they provide interest payments, (after the IFISA provider takes their cut).
Please note that your money is at risk in an IFISA. If borrowers cannot repay loans, you may take a loss.
Providers try to prevent this by spreading risk across a large number of borrowers. However, systemic risks (such as financial crises) may affect the value of your investments.
Also note that it can take time for you to withdraw money. You may need to wait for other investors to buy you out of your loan before you can access your cash.
Junior ISAs allow you to save for your child’s future tax-free.
Under the scheme, you are allowed to save up to £9,000 (for the tax year 2021 – 2022) into a JISA (in addition to the £20,000 personal allowance you have for a regular cash or stocks & shares ISA).
You are also permitted to distribute assets between cash and stocks & shares in a JISA in whatever proportion you like. However, your child cannot access any of the capital until they are 18. You simply manage the account on their behalf.
Parents and guardians like to use this type of account to save for university education or a deposit on the child’s first home.
Do You Need An ISA?
So, do you need an ISA? Well, it depends very much on your lifestyle.
If you are somebody with the ability to save, then putting them into an ISA first could help you improve your long-term financial planning. Exceeding the capital gains tax threshold (£12,300 for individuals in 2021 to 2022) might seem unlikely. But if you invest your money for ten years or more, you may eventually make withdrawals that bring you over the limit.
Both home buyers and people saving for retirement can also benefit from ISAs. In the former case, buyers get access to additional funds for homes, proportional to their savings, paid by the government. In the latter, retirees can also look forward to accessing tax-free savings in the future.
Ultimately, using ISAs is a financially-savvy option for the majority of regular, affluent working people who want to make their money go further.