What is an ISA and how does it work?
An Investment Savings Account (ISA) is a tax-free way to invest your money if you are a resident in the UK.
The advantages of ISAs are that any money that you invest can earn interest or grow in value over time. For most ISAs, you can take your money out at any time, and you won’t have to pay any taxes on that income or growth (capital gains). You won’t need to report it on your tax return.
You can add investments to your ISA every year. You can put in up to £20,000 during the 2020-2021 tax year – this annual limit can change in the future.
Your ISA continues to work year after year, until you withdraw your money.
Different types of ISAs
There are four types of ISAs. You can open one of each. You can invest in one type or split your savings between them every year (not exceeding £20,000 total in a tax year). One exception is the Lifetime ISA, for which you can only invest £4,000 in a tax year.
With the Cash ISA your investments go into savings in a bank or building society account, or into some National Savings and Investments (NS&I) products.
This is a popular, conservative, risk-adverse way to invest. Your cash fairly reliably earns interest, which doesn’t count towards your taxable income. (With other types of non-ISA accounts, you pay taxes on earnings over £1,000). However, the Cash ISA is only a good value when the interest rate is outpacing inflation. Otherwise, you’re actually losing money.
Stocks & Shares ISA
With the Stocks & Shares ISA your investments go into shares in companies, unit trusts and investment funds, corporate bonds and/or government bonds.
The value of these types of investments have greater risk and greater reward potential. The value of the underlying investments, like a company or property, can grow significantly (or drop – be aware). You do not pay any tax of these capital gains or any dividend income from the investments. When you set up your ISA, you will likely have options about what kind of assets (stocks, bonds, etc) you want your money to go into. This can help you adjust your risk profile to your comfort level (bonds tend to be much lower risk).
A Lifetime ISA may include either cash and/or stocks and shares. This type of ISA is generally used to help you save for your first home and/or retirement. Funds can only be withdrawn when you are buying a first home with a mortgage, or you turn 60. Otherwise, you will be charged 25% on the amount you withdraw.
As with the other ISAs, as long as you follow the rules you do not pay income on interest, dividend income or capital gains. You can only invest £4,000 in this account each year. But you get a 25% bonus contribution to whatever you contribute, up to £1,000 per year (£1 for every £4 you invest). So if you put in the full £4,000, your total will be £5,000 that year. You can contribute to your Lifetime ISA until your 50th birthday.
Innovative finance ISA
With an Innovative finance ISA you essentially become a lender. This ISA places your investments in peer-to-peer loans (loans given between people and businesses, without a bank supplying funds), or even “crowd-funding debentures” where you buy into a business’s debt. The borrower pays you back with interest.
The interest rate your Innovative finance ISA charges can be attractive to your bottom line. But be warned, the borrower can fail to pay you back (default on their loan). This is arguably one of the most risky types of ISAs.
Bonus: Junior ISA,
ISAs all have different age restrictions. You must be 16+ for a Cash ISA, 18+ for a Stocks & Shares ISA or Innovative finance ISA, and you must be between 18-40 for a Lifetime ISA.
But you can also gift a child under 18 in the UK a Junior ISA to give them a financial head start. The Junior ISA can be a Cash ISA or Stocks & Shares ISA. Anyone (not just a parent or guardian) can contribute to the ISA’s funds, which becomes accessible to the child when they turn 18. The annual contribution limit is £9,000 as of the 2020-2021 tax year – this is subject to change next year.
How to open an ISA account
For any of these ISAs, you can open one by getting directly in touch with a provider. Depending on the type of ISA you want, this can be a bank, building society, credit union, stock broker, peer-to-peer lending services, crowd-funding companies and other financial institutions.
Not all financial institutions offer all types of ISAs.
What is the best ISA for me?
To find the best ISA for you, first consider a few questions:
What do you want? What are your goals? Many people use ISAs to prepare for their financial future, namely their retirement. Some want easy access to their savings, while others want savings to buy a home.
Decide what you can afford to put in, and what you are hoping to get out. Playing around with figures on an ISA calculator can help you see the possibilities.
And decide your comfort level. Some people are more open to risk, while others prefer a steady interest rate.
Next, choose a provider. You are living in a time when options are everywhere. Think about companies you trust, do some research, and find one that suits your needs. It’s usually easy to transfer ISAs from one provider to another if you change your mind, but beware of exit fees, so check the fine print and compare.
And remember, you can get multiple kinds of ISAs from different providers. So consider diversifying your investment and risk by putting savings into different accounts.
Whatever you do, track it
You want to keep an eye on your investments and see how the value changes over time.
You will also want to regularly put money into an ISA, so you will want to keep an eye on your savings, budgets and other finances to make sure you can continue regular payments.
Money Dashboard can help you keep your eyes on this. The free app gives you a big picture view of your financial activity, helps you set and stick to saving goals, and so much more.