Everything you need to know about ISAs — just in time for the new financial year
With the crash in interest rates and stock markets, there’s never been a better time to make sure you’re being smart with your finances
It’s coming up to Easter, which can only mean one thing: radio, tv, and internet ads encouraging people to open ISAs to help them save and invest their hard-earned cash, with the promise of rewards further down the line.
But what are ISAs, how do they work, and why are those ads appearing now at a seemingly random time of the year? Well, grab a coffee and make yourself comfortable. What follows will hopefully answer all of your questions.
Now, as a heads up, I’m afraid we can’t talk about ISAs without talking about tax — which isn’t typically most people’s choice for an engaging conversation.
Thankfully though, we don’t need to dig into tax matters too deeply. So, let’s keep this top line:
The key facts:
- In the UK, everyone has a ‘tax allowance.’ That essentially means that everyone can earn a certain amount of cash without paying any of it to the government.
- When it comes to savings, you’re allowed to earn £12,000 from investments without paying any tax. By that, I mean, if you invest in companies or buy stocks and shares, you can make a total of £12,000 profit before you need to hand over your hard-earned winnings to the taxman.
- Equally, everyone can earn up to £2,000 a year from Dividends (payments that companies make to their shareholders) without giving any of it up in tax.
However, if you make any more money from your savings, then the difference (i.e. not the total of all of your profits) will need to be declared, and tax will need to be paid.
That’s a real pain, isn’t it? I mean, it’s your money — you’ve done all the research in terms of how best to save or invest it, so why should a percentage of your success be handed over to HMRC?
Well, bear with me, because we’re on the verge of understanding why ISAs are popular with so many savers.
What is an ISA?
An Individual Savings Account (ISA) is a haven for your cash when it comes to tax. It’s a place where you can place up to £20,000 of your savings every year, safe in the knowledge that any profits which are made, will remain 100% yours with no exceptions.
Therefore, if your savings are generating more than the standard tax allowance (described above) or you’re planning to invest long term (so see yourself making more than your tax allowance), then an ISA can help you make significant savings on the tax that you need to pay at the end of each year.
So how does an ISA work?
Everyone in the country has an annual ISA allowance of up to £20,000 without even asking for it.
That means that everyone has the option to put £20,000 every year into various ISA types, without having to pay any kind of tax on the growth of their savings.
A few things to bear in mind though:
- The total annual allowance of £20,000 is across all of the different ISA products. It does not allow you to put £20,000 into each different ISA type.
- The Lifetime ISA (LISA — see below) only allows a maximum investment of £4,000 per year.
- The amount you place in your ISA is measured across the financial tax year (6th April 2020–5th April 2021), not across a typical calendar year.
That’s why you’re seeing all kinds of ISA ads at this time of year — because the new tax year is starting, which means that everyone has another £20k to invest in a brand new sparkly ISA.
What are the different types of ISA?
There are three different types of ISA that you can place your annual £20,0000 of savings into.
Cash
This is the equivalent of a bank savings account. You put your money into a Cash ISA and forget about it. Over the year, you are paid interest on those savings and aren’t charged any tax on the profits.
The thing to bear in mind with cash ISAs is that there are two types: Flexible and Non-Flexible ISAs, so be sure to check which type you’re signing up for.
The difference is as follows:
- Flexible accounts, allow you to replace any funds that you withdraw without it affecting the £20,000 limit that you can put in your ISA each year
- Non Flexible accounts don’t allow you to replace funds.
So, if I put £10,000 into a non-flexible Cash ISA and then decide I need to withdraw £5,000, I’ll only be allowed to put in another £10,000, despite having withdrawn cash.
In that case, I would only potentially be able to put a maximum of £15,000 into savings.
One other thing to bear in mind is you need to be 16 to open a Cash ISA.
Cash ISAs can also be transferred from one provider to another without any impact on your annual ISA allowance.
Therefore, if I decide that I want to transfer my Cash ISA from Barclays to Lloyds (perhaps they pay a higher interest rate?!), I can do so just by signing a few bits of paper and letting Lloyds handle all the dirty work.
Don’t think about withdrawing all your funds from one provider and depositing with another, as it may impact how your annual ISA allowance is viewed.
Stocks & Shares ISA
Rather than placing your cash in a ‘savings account’ for a typically small interest rate (the Cash ISA, above), it’s possible to invest your savings into the stock market via a Stocks and Shares ISA.
This particular ISA product means that you won’t pay any tax on:
- The profits made from those companies or funds that you chose to invest in (known as Capital Gains Tax)
- Any dividends paid to you by the companies/funds that you’ve chosen to invest in.
You need to be at least 18 to own a Stock and Shares ISA, and you can transfer it from one provider to another easily. As with the Cash ISA, if you find a provider that you prefer, you can simply request a transfer, and they will do all the work for you in terms of switching your investments across.
Lifetime ISA (LISA)
Now the LISA is a very different kettle of fish when compared to the other ISA products listed above.
For starters, you have to be between 18–40 to invest in a LISA. Once you’ve gone past forty, it’s impossible to open one up.
In addition, while you can invest up to 20,000 a year in either of the products listed above, you can only invest £4,000 a year in a LISA — and even then, you can only invest in it up to the age of 50, at which point all investment stops.
The main benefit of a LISA though is that the government will add 25% of your annual investment into your LISA with no questions asked. So, for example, if you max out your LISA investment and put £4,000 into it over the tax year, the government will give you an additional £1,000 out of the goodness of their hearts.
The other way that the LISA differs from other ISA products is around the conditions for withdrawing your cash.
Whereas the other products are fairly flexible around you withdrawing funds (with the only real penalty potentially being impacting your annual ISA limit), the LISA only allows you to withdraw your cash in three specific scenarios:
- You reach the age of 60
- You want to buy your first home. And even then, there are restrictions:
- You have to be taking out a mortgage to buy the house
- The house can not be more than £450,000 in value
- You have to have your LISA open for at least a year before withdrawing funds
- You are terminally ill with less than 12 months to live
If you withdraw your funds for any other reason, you’ll be hit with a 25% penalty charge.
JISA
The other product that you might be tempted to put your cash into is the Junior ISA — but be aware, the JISA is not for you, it’s for your children.
JISA’s come in Cash and Stocks and Shares variants (just like their bigger brothers), and as a parent or registered carer, you can invest up to £9,000 per year for each child that you have.
Once you’ve invested the cash though, it belongs to your child. They can take control of their JISA by the time that they’re sixteen, although they won’t be able to make any withdrawals until they’re eighteen.
Summary
If you’re a large investor or looking to invest over the long term, then an ISA will benefit you heavily when it comes to having to pay tax on your investments.
The younger you are, the more value you’ll get out of them. Especially if you’re looking to invest in the LISA, whereby the government will provide you with a guaranteed return on your investment every year until you hit the age of fifty.
Also, an ISA will save regular investors from the hassle of having to add up their returns for their annual Self Assessment return for the tax office. As the ISA is a government scheme which is designed to be tax-friendly, then you don’t even need to mention your investments when it comes to submitting your tax return.
In addition, while this is in no way guaranteed, your annual ISA allowance is also likely to rise over the long term. Initially, individuals were only allowed to invest £10k into an ISA. That has since gone up to £15k and now to £20k. So the chances are that the allowance will increase further over the next few years.
So what’s the catch?
Well, the short answer is that there isn’t one. However, you should bear in mind that you’ll typically have to pay a small annual fee for the benefit of having an ISA.
The fee will depend on who you decide to take your ISA out with, but will likely be anywhere from around £3 to £10.
Given the savings that you’ll make from not paying tax, this should be a drop in the ocean. However, it does mean that if you’re still within your personal tax allowance (the £12,000 detailed above), you’ll financially be better off not paying for an ISA.
You will, however, need to detail all of your investments to the HMRC on an annual basis. Therefore, you probably need to think about whether a small annual fee is worth not having to pull together all that information on an annual basis for the taxman.
