What is an ISA?
Independent Savings Accounts, or ISAs, can come in two versions, cash or stocks and shares and are available to any UK citizen or crown dependent 18 years old or over.
The best ISA account analogy I’ve come across was coined by the sage-like Martin Lewis. He describes your savings and shares as like slices of cake and the ISA as a sort of tax free wrapper that stops the tax man from taking a bite.
ISAs operate in much the way that many savings accounts or investment vehicles do, except they are exempt from tax. This wrapper has an upper limit however, one that is reviewed annually by the UK Government and comes into effect every April.
How does the Yearly Tax Free Allowance work?
The current yearly tax free allowance is £11,520, of which half (£5,760) can be invested into a cash ISA, the most common form of ISA.
If you have £11,520 to put into ISAs then there are three possible ways of investing it.
First of all you can put it all in a stocks and shares ISA, of which there are many different types and means. There is a risk in putting your money into these kinds of financial instruments so be wary of investing all your tax free allowance into this kind of ISA.
The second option is to put £5,760 into a cash ISA and the remaining £5,760 into a stocks and shares ISA.
The third option is to put less than £5,760 into the cash ISA and the remaining tax free allowance into the stocks and shares ISA.
What are my Options with a Cash ISA?
Of course many people don’t have £11,520 sat in their bank account and so the options will be a little different. The best advice would be to put as much as you can in a risk free Cash ISA account.
You can invest this money in one of two ways and there are two different types of cash ISA that reflect these different ways of investment.
A Fixed Rate Cash ISA does exactly what it says of the tin and pays out a fixed rate of interest, usually over a year but sometimes this can be up to 3 years or more. Although the terms and conditions of every ISA will be slightly different the one thing that all fixed rate cash ISAs will tend to have in common is a penalty for withdrawing your cash to early, usually a reversion to a lower rate of interest. In this way, fixed rate ISAs are best used when you don’t require access to your savings for a considerable period of time.
Regular Savings ISAs allow you to invest your yearly tax free allowance in increments. Because these types of ISAs are generally a lot more flexible, the interest rates are lower than those found on fixed rate ISAs. The compound interest is of course lower as well as the interest rate is dropped every month as you approach the end of the tax year.
Should I think about a Stocks and Shares ISA?
Unless you are putting a lot of money into these types of products then it’s unlikely that you will see any real benefit from using your ISA allowance to invest in them.
The reason is that the tax savings here is based on capital gains tax, which in the case of shares, isn’t paid on profits under £10,600 a year. Unless you really got lucky or have hit the big time then it seems unlikely you’ll be making this amount and so the ISA wrapper won’t come into play anyway.
The same is true of dividends which will be taxed at the 10% basic rate, regardless of the tax free wrapper. Your ISA will only benefit you when this rises to 32.5% for higher rate tax payers or 37.5% for additional tax rate payers, as the rate stays fixed at 10%.
Most bonds don’t incur tax anyway so again the benefits of the ISA are not felt here either.
The long and the short of it is, stocks and shares ISAs are only beneficial to larger more affluent investors. If this isn’t you then it’s advisable to stick to the cash ISA.