What is an ISA (Individual Savings Account) & which is best?
What is an ISA (Individual Savings Account) & which is best?
What is an ISA and what does ISA stand for?
ISA stands for Individual Savings Account, a type of tax-free savings and investment wrapper in the UK. In an ISA, UK residents can deposit a limited amount of money each tax year into one or several different types of ISA (an ISA allowance) and the capital gains, interest and any income received over time is tax-free.
In broad terms, the money that goes into an ISA has typically already been taxed (such as money from your take-home salary), so it's taxed-in, tax-free out. The money contributed into a pension on the other hand is typically pre-income tax, so it's tax-free-in and taxed-out. This is very generalised but it helps to illustrate the difference.
The money held in an ISA is typically accessible whenever you want it, subject to the terms of any fixed-term agreement, whereas the money held in a pension is usually only accessible when you are eligible for the pension freedoms (this is currently age 55 but soon increasing to 57).
A further benefit of an ISA is that you don't need to declare details of income, interest or capital gains on your tax return.
Remember that your ISA accounts don't close at the end of each tax year, you can continue to contribute to the accounts or open new ones with different providers. You can also transfer the balance between your accounts.
What different types of ISA are available?
In the UK, there are several types of Individual Savings Accounts available:
Cash ISA
Stocks and Shares ISA
Junior ISA (Which can be a Cash Junior ISA or Stocks and Shares Junior ISA) or ‘JISA’
Lifetime ISA or ‘LISA’
Innovative Finance ISA
Most people are familiar with a Cash ISA, however, some of the other types of ISA available offer real opportunities for those looking to invest in a tax-efficient way.
To open an ISA in the UK, you must be:
A resident (or Crown servant).
Aged 16 or over for a Cash ISA.
Aged 18 or over for a Stocks and Shares ISA or Innovative Finance ISA.
Aged 18 or over but under 40 for a Lifetime ISA.
Aged under 18 for a Junior ISA.
What is an ISA allowance?
An ISA allowance is the maximum amount of money that can be contributed into ISAs each financial year (6th April to the 5th April). You can choose to put your whole allowance into one single ISA or spread it across all the different types that you are eligible for. However, you can only contribute into one of each ISA type each financial year.
In the financial year 2021/22, the headline ISA allowance is £20,000, reducing to £9,000 for a Junior ISA (per child) and £4,000 for a Lifetime ISA (but the Lifetime ISA allowance is part of your headline allowance).
To illustrate how an ISA allowance could be used:
You could put £15,000 into a Stocks and Shares ISA and £5,000 into a Cash ISA.
Or you could put £4,000 into a Lifetime ISA, £6,000 into an Innovative Finance ISA and £10,000 into a Cash ISA.
And alongside either of the above, you could put £9,000 into a Junior ISA for each of your children.
What is a Cash ISA
A Cash ISA is essentially a tax-free savings account whereby money is deposited with a bank or provider and the cash will be subject to fixed or variable rate interest payments and your money will either be easy-access or tied up for a period of time. The rates are typically very low but you will earn more the longer your money is tied in.
However, following the recent introduction of the Personal Savings Allowance that enables basic and higher-rate taxpayers to earn £1,000 and £500 of interest tax-free each year respectively, Cash ISAs have fallen slightly out of favour with those with smaller levels of cash.
Nonetheless, for additional rate taxpayers and those looking for a home for larger cash sums that don't wish to be subject to investment risk, a Cash ISA could be a great place to earn tax-free interest.
Cash ISAs are often provided by banks and building societies, although many are online-only. National Savings and Investments also offer some Cash ISA accounts to consider.
What is a Stocks and Shares ISA?
A stocks and shares ISA is an account that allows the holder to invest in a range of publicly traded assets that could include shares in companies, corporate bonds, government bonds, unit trusts and investment funds. Many investors will choose a Stocks and Shares ISA as their main investment vehicle outside of their pension due to the benefits of tax-free growth, tax-free income and easy access to their funds.
Stocks and Shares ISAs are offered by larger investments firms and you can choose between DIY platforms for total control or Robo-Advice that chooses investments based on how you respond to a series of questions around risk tolerance and purpose. Or you can receive full advice from a regulated Financial Adviser, which is sensible for larger sums of money.
Clearly, investing in the stock market is much higher risk than a basic Cash ISA and you could get back less than you put in, however it does offer the opportunity for unlimited returns.
What is a Lifetime ISA?
A Lifetime ISA is a bit of an oddity as not only is the income and growth tax-free, but the government will add a 25% boost to your savings. The headlines are good, but there are a few caveats:
You must be 18 or over but under 40 to open a Lifetime ISA.
A Lifetime ISA can hold cash or stocks and shares.
The annual contribution limit is £4,000 up until age 50.
You must make your first payment into your ISA before you're 40.
The government 25% bonus has a cap of £1,000 per year.
Furthermore, you can only withdraw money from your Lifetime ISA if you are:
Buying your first home.
Aged 60 or over.
Terminally ill, with less than 12 months to live.
If you decide that you want to withdraw your money for any other reason, you will be subject to a withdrawal charge of 25% to recover the government bonus you received on your original savings.
The general aim of a Lifetime ISA is to give younger adults savers a decent cash boost to help with building a house deposit, without having to expose their savings to significant risk, if they don't wish to. For example, a 10% deposit on a £300,000 house is £30,000. Without any interest, a saver would have to contribute £4,000 a year to a LISA for 6 years to raise their deposit ((£4k cash + £1k boost) x 6 years).
The other reason for a Lifetime ISA is to function like a tax-free pension, however, given the low annual contribution limit and limited government bonus, claiming tax relief on pension contributions may be a better strategy and simpler to administer. Equally, whether or not you wish to tie your money up with this level of restriction is a decision every saver must make.
What is an Innovative Finance ISA?
'Innovative Finance' may sound a little advanced, however, an Innovative Finance ISA is just a way to hold peer-to-peer loans and what's known as 'crowdfunding debentures’ in a tax-free wrapper.
Innovative Finance ISAs include:
peer-to-peer loans - loans that you give to other people or businesses without using a bank
crowdfunding debentures - investing in a business by buying its debt
Can I transfer money between ISAs?
Yes, you can transfer money between Cash ISAs, Stocks and Shares ISAs and Innovative Finance ISAs, providing you are operating within the terms of any fixed period of investment. You may wish to do this if you have seen great gains on some shares in your Stocks and Shares ISA and want to diversify into peer-to-peer lending via an Innovative Finance ISA, for example.
The only way to transfer your LISA without incurring the withdrawal charge is to transfer it to another LISA. You can’t transfer it to a Cash ISA for example.
Conclusion, what is the best ISA?
As you can see, ISAs vary broadly and there is something out there for everyone at every life stage. Cash ISAs represent a way for savers to isolate large sums of money from tax on the interest; Stocks and Shares ISAs work well as a general base for investors that want exposure to stock markets in a tax-free environment; Lifetime ISAs are worth considering for younger investors that are looking to buy a house; and Junior ISAs are a great way to transfer wealth over time to your children and give them a head start in life.
What’s your favourite ISA and why did you choose it? Do you find a combination that works best? Let us know in the comments below and start the discussion.
What’s next?
If you need advice on pensions or how you can invest for the future, you can get in touch with one of our advisors for independent financial advice. We offer a free initial consultation and although we are based in Tunbridge Wells, we advise clients across the UK.
Don’t forget, this article offers information about financial planning and investing and should not be taken as personal advice. Remember that investments and pensions can go up and down in value, so you could get back less than you put in. Tax rules can change and the benefits depend on individual circumstances.