If you’re contemplating the best place to allocate your savings, an Individual Savings Account (ISA) might be on your radar. An ISA allows you to deposit up to £20,000 each year without incurring taxes on any profits you generate. This means that your earnings remain free from capital gains tax, dividend tax, and other similar taxes. Below, we delve into the specifics.
What are the different types of ISA?
There are four primary types of ISAs available: cash ISA, stocks and shares ISA, lifetime ISA, and innovative finance ISA. Additionally, you can open a Junior ISA to save or invest on behalf of a child.
- Cash ISA: This is akin to a traditional savings account, but with the advantage that you don’t pay tax on the interest earned.
- Stocks and Shares ISA: This option allows you to invest in a variety of assets, including funds, bonds, and individual company shares. Just like with a cash ISA, any income or gains from these investments are free from dividend and capital gains taxes.
- Lifetime ISA (LISA): With this type of ISA, you can contribute up to £4,000 per tax year, either to purchase your first home or to save for retirement. The government adds a generous 25% bonus on your contributions. However, be aware that withdrawing funds for reasons other than purchasing a first home or retirement incurs a penalty of 25%, effectively resulting in a 6% loss on your savings.
- Innovative Finance ISA: This ISA features peer-to-peer loans, connecting investors with borrowers. These accounts often yield higher interest rates compared to conventional savings accounts, but they come with significant risks, as evidenced by the collapse of several platforms in recent years.
What should you look for?
As the new tax year approaches on April 5, now is an opportune moment to consider how to allocate your savings. Rajan Lakhani, a personal finance expert at Plum, highlights that there are “some excellent rates available currently, enabling you to counter inflation.” He advises, “Look for an account offering more than 5% interest—fintech companies and smaller banks often provide more competitive rates than traditional high-street banks.” While securing such rates may be challenging due to declining interest rates, they are still within reach. Lakhani also emphasizes the importance of ensuring that your cash ISA is safeguarded by the Financial Services Compensation Scheme (FSCS).
What type of ISA should you choose?
According to Paul Carlson, managing partner at Law Firm Velocity, the choice depends on your risk tolerance and return expectations. He states, “If you prefer a conservative approach, a cash ISA is ideal. It allows you to store your money safely while earning interest without the worry of taxes diminishing your returns.” Conversely, if you’re seeking growth, he suggests a stocks and shares ISA, which offers tax-free gains on investments in shares or funds, without the need to report these on your tax return.
Claire Exley, head of advice and guidance at digital wealth manager Nutmeg, adds that your investment horizon is also crucial. “If you anticipate needing access to your funds within the next three years, a cash ISA might be more suitable for you. Ensure there are no withdrawal restrictions on fixed-rate accounts,” she advises. “However, if you have a longer-term goal, investing in stocks and shares may provide a better chance of outpacing inflation.”
It’s essential to understand that investing in stocks and shares carries inherent risks, and there’s no guarantee of returns—there’s always the possibility of losing money. If you’re saving for your first home, the Lifetime ISA could be advantageous due to the 25% government bonus on your contributions. However, keep in mind the withdrawal penalties if you use the funds for purposes other than buying a home or planning for retirement. Additionally, the LISA is applicable only for properties costing £450,000 or less.
Opening multiple ISAs to cater to different financial objectives is also a viable strategy. Brian Byrnes, head of personal finance at Moneybox, suggests that the £20,000 ISA allowance can be diversified across various ISA products tailored to your financial goals. This might include a Lifetime ISA for first-time home purchases, a cash ISA for mid-term savings, or a stocks and shares ISA for long-term growth.
“The tax benefits of ISAs are immense,” Byrnes concludes, “so regardless of your savings or investment aims, it’s crucial to evaluate whether you’re utilizing a tax-efficient approach. This may even involve transferring your savings or investments into an appropriate ISA to avoid substantial tax liabilities in the future.”
How do you open an ISA?
Most banks and investment platforms allow you to open an ISA online, a process that typically takes around 10 minutes. You’ll need to provide identification and some personal information. Once your account is established, you can either transfer funds from your bank or move existing savings from another ISA. Remember, it’s essential to stay within the £20,000 limit for each tax year.
