Using your Individual Savings Account (ISA) allowance each tax year (which runs from 6 April to 5 April) is one of the best ways to reduce the tax you pay on your savings and investments. But what type of ISA should you choose?
The first decision is whether to keep your tax-free savings in cash or invest in stocks and shares. The vast majority investors opt for the latter; of the 13 million adult ISA accounts opened in 2019-20, only 1.2 million were cash accounts, government figures show.
But the right choice for you will depend on:
- Your attitude to risk – stock market investments can go down as well as up, but you should never usually get less back when you save in a cash account
- Your savings goals – over the long term, stock market investments can ride out any ups and downs, which is why they work best over at least five years
Here, we explain how ISAs work and offer some pointers on choosing the right one for you.
What is an ISA?
An ISA is a tax-efficient wrapper you can use to shelter a certain amount per tax year, currently £20,000, in savings or investments from income tax, tax on dividends, and capital gains tax.
There are five different types:
- Cash ISAs – available from banks, building societies, and National Savings & Investments
- Stocks and shares ISAs – available from stockbrokers and fund managers
- Innovative Finance ISAs – available from peer-to-peer lenders
- Lifetime ISAs – available from a variety of financial institutions
- Junior ISAs – available from a variety of financial institutions
You can only get an ISA if you are a UK resident, although Crown servants such as diplomats can open ISAs even when based overseas.
Your age determines the type of ISA you can have. Under current rules, you can open a cash ISA at 16, but you must be 18 to open a stocks and shares or Innovate Finance ISA, while to start saving into a Lifetime ISA you need to be aged between 18 and 39.
How do ISAs work?
ISAs work like other savings and investment accounts, just with a few more rules. For example, while you can invest your annual ISA allowance into one ISA, you can also choose to split it between accounts of different types – as long as you do not exceed the £20,000 annual limit.
But, unless you choose a flexible ISA that allows you to withdraw cash and pay it back in during the tax year, any money withdrawn will still count towards your annual allowance.
And while switching ISA providers is also possible, you have to transfer the money directly between providers. If you withdraw money to pay into another account elsewhere, you risk losing your allowance for that tax year.
Why should I get an ISA?
Most UK taxpayers have a personal savings allowance that allows them to earn a certain amount in interest tax free. For basic rate taxpayers, this amount is £1,000 per year; for higher rate taxpayers it’s £500.
However, additional rate taxpayers pay tax on all savings interest – unless it’s earned within an ISA.
Stock market investors also receive a dividend allowance that mean they only start paying tax once their earnings exceed a certain amount, currently £2,000 a year.
Above that, they pay tax at between 7.5% (basic rate) and 38.1% (additional rate) – again, unless the shares are held in an ISA.
In other words, ISAs are a no brainer for savers and investors with large balances or portfolios, especially if they pay tax at the additional rate.
There’s also a “use it or lose it” argument for making the most of your ISA allowance each tax year, as failing to do so means missing out once your allowance expires on 5 April.
If you have the money available, financial advisers therefore generally recommend using your entire ISA allowance every year.
What different types of ISAs are available?
The two main types of ISA are cash ISAs and stocks and shares ISAs. Other options include Innovative Finance ISAs, through which you earn interest by lending your savings to borrowers on peer-to-peer platforms (the risk being that they fail to pay you back).
If you’re aged between 18 and 39, you can also take out a Lifetime ISA, into which you can pay £4,000 each year and benefit from 25% annual government bonus, as long as you leave the money where it is until you need it to buy a house or to fund your retirement.
Parents and grandparents can also invest up to £9,000 a year into Junior ISAs to be claimed by the child in question at age 18. For all but Innovative Finance ISAs, the main decision remains whether to invest in cash or stocks and shares accounts.
Cash ISAs explained
Cash ISAs are simply savings accounts that are protected from tax by an ISA wrapper and can be used to hold all or some of your ISA allowance each year.
They come in a wide range of forms, including easy access, variable-rate accounts and fixed-rate accounts, usually lasting between one and five years.
But while you can have several different ISAs, you can only open one cash ISA per tax year.
Pros
- They are easy to open and run
- They can be a good home for savings you want to access within the next five years
- They allow you to avoid paying tax on interest over £1,000 a year – both now and in the future
- For higher earners, they are the only way to have a tax-free savings account
- They are safe – the Financial Services Compensation Scheme (FSCS) covers the first £85,000 held with each Financial Conduct Authority-authorised provider
- They can be inherited by your partner or spouse without affecting their ISA allowances
Cons
- They are unlikely to provide higher returns than stocks and shares accounts over time – especially in a low interest rate environment
- They don’t always offer such high rates as normal savings accounts
- If you earn less than £1,000 in interest per tax year, there’s no real tax benefit (potentially making a higher rate savings account a better choice).
Choosing a cash ISA
The interest rate paid is the main consideration when choosing a cash ISA. However, the right account for you will also depend on factors such as:
- Withdrawal conditions: While some cash ISAs allow you to withdraw your money penalty free at any time (and without affecting your ISA allowance if they are flexible accounts), most of those offering higher rate of interest require you to lock your cash away for a time – say two, three, or five years
- Rate and term: Fixed-rate cash ISAs with set terms tend to offer higher rates, but if interest rates are rising is it really the time to fix your rate for the next five years?
- Ease of management: Some cash ISAs can be opened and managed online, while others can only be opened in a branch. Others require you to make regular payments, pay in a certain amount to open the account, or give 30 days or more notice to access your savings.
Stocks and shares ISAs explained
Stocks and shares ISAs can be used to invest in company shares, unit trusts and investment funds, corporate bonds, and government bonds.
Like investments of all kinds, they come with an element of risk: the value of your bonds, fund, or shares can go down as well as up. However, statistics show that investments consistently outperform cash savings over the longer term.
As with cash ISAs, you can only open one stocks and shares ISA per tax year.
Pros
- They protect any growth or income from tax
- They generally offer better returns than cash accounts over time
- They can be used to access a wide range of investments
- They are safe – the Financial Services Compensation Scheme (FSCS) covers the first £85,000 held with each Financial Conduct Authority-authorised provider (in the case of the provider going bust, not of your investments losing money)
- They can be inherited by your partner or spouse without affecting their ISA allowances
Cons
- They can fall in value if your investments fail to perform
Choosing a stocks and shares ISA
Not all investments carry the same level of risk. Government bonds, for example, are generally less volatile than individual company shares. You can also reduce the risk involved in stock market investing by choosing a mix of assets across different sectors and geographies. That’s why many ISA investors choose funds run by professional investment managers.
Other things to consider include:
- Charges – how much do you have to pay per year, both for the account and for any funds you invest in?
- Ease of management – can you manage your account online?
- Investment goals – what do you want to achieve and how long do you have to do it?
Cash and stocks and shares
You don’t have to choose between a cash ISA and a stocks and shares ISA, you can split your £20,000 allowance between the two.
If you’re concerned about investing all your ISA money in a volatile stock market, you can also choose to keep it in a linked cash account for the moment and drip feed it into the market over the next 12 months.
