ISAs: What You Need to Know
Put simply, ISAs are a type of savings or investment account that shelters your nest egg from tax. Our guide will help you find one that's right for you.
An individual savings account, or ISA, is a useful way to build your savings or investments without worrying about tax, both now and in the future. Knowing its benefits and what to look for can be a first step toward securing your financial future.
So, make a cup of tea, set aside a few minutes and read this. By the end you’ll know what kind of ISA is right for you and be ready to compare the best deals.
Why do I need an ISA?
ISAs protect you from needing to pay tax on your savings and investments. On its face, that sounds fantastic. But there's more context to consider.
In 2016 the government made a massive change to savings and introduced the personal savings allowance. This allowance means that basic-rate taxpayers can earn £1,000 in interest each year on cash accounts before they need to pay tax, and higher-rate taxpayers can earn £500 a year. There’s no allowance for top-rate taxpayers. With interest rates remaining so low, this means most basic-rate taxpayers would need to have tens of thousands of pounds stashed away before they risked troubling the taxman at all.
So, some people who just want to save into a cash account might question whether they need an ISA, especially if they can get a better rate on a standard savings account.
But it’s worth considering whether an ISA will help future-proof your savings. After all, interest rates may climb again, and if you’re saving for the long term you may put away a larger amount than you realise.
What are the different types of ISAs?
There used to be two kinds of ISA – cash accounts, or stocks and shares. Now there are quite a few to choose from.
For adults, there are four types of ISA available.
Cash ISAs. Just as with a normal savings account there are different types, such as easy access or fixed-rate cash ISAs. Look for accounts paying the highest rate of interest you can get while offering the access to your cash that you need.
Stocks and shares ISAs let you hold investment products like corporate bonds, funds and, of course, actual stocks and shares in a tax-free wrapper. When held in an ISA, your investment growth or interest is not subject to tax. You can get a stocks and shares ISA from an online investment platform; these will charge a fee for their services, so shop around to make sure you don’t pay too much.
Lifetime ISAs let you save a maximum of £4,000 a year, and then the government tops it up with a 25% bonus. So if you save £4,000, that sum becomes £5,000. A Lifetime ISA can be invested in cash or stocks and shares, but you can only use it to buy your first home or save for later life. This means you will usually have to pay penalties that exceed the bonus if you withdraw it for any other purpose (unless you are terminally ill).
In normal times you’d pay a 25% penalty to withdraw money from your Lifetime ISA. However, in the current crisis the government has lowered the withdrawal penalty to 20% until April 2021.
Innovative finance ISAs allow you to put your money into areas like peer-to-peer lending, peer-to-business lending and crowdfunding. Then, whatever interest you make is not taxed because it’s held in a tax-free wrapper. Of course, as with stocks and shares ISAs, this is considered riskier than holding your money in cash, because the people or businesses you are lending to may default on their loan.
Once you’ve worked out what type of ISA is right for you, be sure to shop around to find the best deal.
ISAs for children. For anyone under 18, there are also Junior ISAs. Interestingly, that means that any 16- and 17-year olds who have a lot of cash to save can actually open both adult and junior accounts and benefit from both allowances. Like adult ISAs the money can be invested in cash or stocks and shares, but unlike the grown-up version, instant access isn’t an option. Savings can only be withdrawn once the child turns 18.
What about Help To Buy ISAs? Help To Buy ISAs are no longer available to new savers; you’ll need the Lifetime ISA instead. But if you have an existing Help To Buy ISA you can keep saving into it until 2029.
How to choose an ISA
All the different accounts have pros and cons, so you need to think about your personal circumstances and why you are saving.
Cash ISAs are straightforward and usually simple to withdraw your money from. And your cash is covered by the Financial Services Compensation Scheme up to £85,000, so you have extra protection. But current interest rates on cash ISAs are pretty low and could be outstripped by inflation.
A stocks and shares ISA or an innovative finance ISA hold out the promise that your money could grow faster. The downside is there’s more risk – investments can go down as well as up. (The Financial Services Compensation Scheme does cover investments, too, on up to £85,000.) Also, it can be a longer process to extract your cash — you have to sell investments or close P2P lending — so you may not get instant access to your money.
Lifetime ISAs come with that 25% bonus and are great if you want to save for a house or retirement. But if you need to withdraw your money for any other purpose, you likely will pay a steep penalty.
Your ISA questions answered
Who can get an ISA?
As long as you are a UK resident aged at least 16, you can open a cash ISA. You have to be 18 or over to open a stocks and shares ISA or an innovative finance ISA.
Can I switch ISAs?
Yes, but there is a process to follow. If you simply close one account and open a new one, you will lose the tax-free status of that cash. Instead you need to ask your new ISA provider to transfer the money for you. You just need to check that your new provider accepts transfers and check for any transfer fees.
Can I withdraw my money and pay it back in?
Some ISA providers allow you to take money out of an ISA and pay it back in, as long as you do so in the same tax year. Check first, before you make a move.
How many ISAs can you have?
You are limited to opening one of each type of ISA in any one tax year. And although you can keep old accounts, you can only carry on making payments into the most current one.
How much can you put in an ISA?
The annual ISA allowance for adult ISAs in the 2020/21 tax year is £20,000, but you can split it across the various ISA types in any way you like. For example, half in stocks and shares, then half in cash.
Junior ISAs have a lower allowance of £9,000 in the current tax year.
Lifetime ISAs have an annual limit of £4,000, so if you want to save more you’d need to open another account.
Are ISAs tax free?
Yes. Any money you earn in interest on ISA savings or from your ISA investments is paid tax free, and you don’t have to pay any tax when you withdraw the money either.
Where can I learn more?
If you’re new to savings or if you just want to learn more about making the most of your money then check out our guides. From the personal tax allowance to starting to save, we have everything you need to know.
Felicity is a personal finance journalist. She regularly writes for The Times, The Mirror and The Independent. She has won five awards for her work, including Household Money Journalist of the year. Read more