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Ultimate Guide to ISAs - What is an ISA

What is an ISA?

Every resident in the UK who is over the age of 18 (or 16 if only looking at cash ISAs) can invest up to £20,000 in an ISA in the 2021/22 tax year and it could be invested in a combination of stocks and shares ISAs, cash ISAs, Innovative Finance ISAs or Lifetime ISAs.

An ISA is an “Individual Savings Account” and is a type of tax- free account, which can be used by savers or investors to hold either cash or investments.  However, over the years they have become increasingly complex, with many people struggling to understand the different types of ISA available, let alone work out how much they can put in which, at what stage.  As such this guide is designed to help you cut through the complexity and maximise the benefits of using ISAs to your advantage.

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Why Use an ISA?

Think of an ISA like a bag that you put your savings or investments inside to protect them from the grabbing hands of the taxman.

Any interest, dividends and profits you make is free from tax and you don’t have to include them on your tax return.

Any cash you take out won’t be hit by income tax so you can invest or save money tax efficiently.

There are a number of different types of ISAs, whether you are looking to save for your kids, a house, the shorter or longer term:

  • Cash ISAs
  • Stocks and shares ISAs
  • Junior ISAs
  • Lifetime ISAs
  • Innovative finance ISAs

And variations of the above.

You can only pay a total of £20,000 into ISAs in any tax year (correct at 20/21 tax year), split across as many different types as you please in whatever amounts you like (although the Lifetime ISA has an annual limit of £4,000).

Much like bags, ISAs come in lots of different sizes and styles

Is it worth having an ISA 2021?

Cash ISAs aren’t as popular as they once were due to the introduction of the Personal Savings Allowance (PSA):

  • Basic-rate taxpayers – can earn £1,000/year in interest without paying tax
  • Higher-rate taxpayers – can earn £500/year in interest without paying tax
  • Additional taxpayer earning £150,001 or more – no allowance

Therefore Cash ISAs particularly appeal to 45% additional-rate taxpayers, and savers with bigger balances, who want to make sure any interest stays tax-free, and particularly if interest rates rise at some point.

You might also want to consider a stocks and shares ISA.  They are more risky than a Cash ISA but have the potential to generate higher returns, although there is knowledge required about investing to gain the full benefit.  You can put away up to £20,000 per year free from the taxman and protecting it from any future UK tax policy changes (although it is unlikely but always possible that tax rules could change and ISAs could cease to exist or receive such generous tax treatment).

A brief history of ISAs

Back in 1999, the then Chancellor Gordon Brown announced the introduction of the ISA. While they have since become an integral way to save, they were not welcomed when first introduced. In fact they were branded a “colossal failure” by Labour MP Quentin Davies just months after they launched. Despite the initial negative outlook for ISAs, they did eventually become an important part of many peoples’ financial strategy; £870 billion has been placed in ISAs in the last two decades.

The key benefit of saving in an ISA has remained the same throughout the last 20 years; the gains you make from interest or investment returns are tax-free. This incentive reflected the tax-efficient alternatives that the ISA replaced. The now defunct Personal Equity Plans (PEPs) are broadly similar to a Stocks and Shares ISA, while a Cash ISA is comparable to the obsolete Tax-Exempt Special Savings Accounts (TESSAs).

When they launched, the ISA allowance was split between investing and cash. For the tax year 1999/00 the allowance was £7,000 for a Stocks and Shares ISA and £3,000 for a cash account. Splitting the subscription limit between the two types of ISA changed in July 2014, allowing you to distribute your money across ISAs in a way that suits you. The current annual subscription limit is £20,000, where it has been since 2017/18.

What's the best type of ISA?

The best type of ISA for you depends on you and your personal circumstances. To find the right one, you need to ask yourself:

  • What are my financial goals? – what do I want to use the money for eventually?
  • What is my time frame? – when am I likely to want to use that money?
  • What is my attitude to risk? – how happy am to accept some risk in order for my money to grow?
  • How hands on do I want to be? – for example, do you want to pick and choose what investments go into your stocks and shares ISA or are you happy leaving it to a professional Investment Adviser?

Main features of the different ISAs:

  • Cash ISAs:
    • good for an emergency fund for those who don’t like risk.
    • if you have a short time frame to save for.
    • if you think you will want to access your money quickly.
    • if you are an additional-rate taxpayer or saver with a bigger balance.
  • Stocks and shares ISAs:
    • Better for longer term savers.
    • Suitable for those who don’t mind a bit of risk.
    • can be as hands on or off with your investments as you like.
  • Junior ISAs:
    • suitable for kids.
    • comes in cash and stocks and shares versions depending on your timeframe.
  • Lifetime ISAs – used to buy your first home or for retirement savings.  Comes in cash and stocks and shares versions.  There is an annual limit of £4,000 per annum and you are only eligible to open one if you are between 18 and 40.
  • Innovative finance ISAs:
    • Best for seasoned investors who understand peer-to-peer lending.
    • Suitable for those comfortable with taking more risk with their money.

Using your ISA allowance

Each year, you can put away up to £20,000 in ISAs between April 6 one year and April 5 the next. The junior ISA is separate and it has its own limit.

So for example, if you had £20,000 spare in a single UK tax year, you could split it:

  • £4,000 in a lifetime ISA
  • £3,000 in an innovative finance ISA
  • £2,000 in a cash ISA
  • £11,000 in a stocks and shares ISA

For a total of £20,000.  The ISA limits are “use it or lose it” allowances – you can’t carry forward any unused ISA allowance from one year to the next.

The golden rule is you cannot pay into more than one ISA of the same type in the same UK tax year.  e.g. you couldn’t open up and contribute to a Cash ISA with Halifax and another Cash ISA with HSBC in the same tax year.

However, it’s fine to open one with one provider, then leave that money to grow while opening another one with a new provider in a new tax year.  Once you open an ISA, you can move the money to a different provider in an ISA transfer but don’t take the money out yourself or you’ll lose the tax benefits.  A transfer doesn’t count toward your one ISA a year limit.  Tell the new company you want an ISA transfer from an existing ISA and let them sort it out.

Transferring ISA providers could make a lot of sense if you want to simplify your finances, cut costs or earn extra income.  Make sure that any ISA provider you choose is regulated by the Financial Conduct Authority by checking the Financial Services Register.

What happens to ISAs on Death

Before April 2015, when you died, the tax efficiency of your ISA portfolio died with you, meaning that any surviving spouse would not continue to benefit from the tax-free income or growth enjoyed during your lifetime.  But thankfully this has now changed.

From April 2015, if you were married or in a civil partnership and your spouse or civil partner died on or after 3 December 2014, you will benefit from an additional ISA allowance (known as an Additional Permitted Subscription) equivalent to the value of their ISA accounts. You do not have to inherit the money actually held in the ISA to make use of the Additional Permitted Subscription.

The Additional Permitted Subscription allowance is available for a period of up to three years after your spouse’s death, where the investment is made as cash.  The only exception is if the administration of the estate takes a significant amount of time, then you have up to 180 days after the date the assets are distributed from the estate, if this means the time is greater than three years.

New rules introduced in April 2018 mean that an ISA will now become a ‘continuing account of a deceased investor’ and will continue to benefit from the tax advantages of an ISA. No further money can be paid into the ISA but the tax free status will last until the administration of the estate is complete, the closure of the ISA or three years after the death of the account holder, whichever is earliest.

This is a key change, as previously, any income or growth arising from the date of death of the account holder on all ISAs became taxable, therefore it now allows the surviving partner to earn tax-free growth on the funds held until the estate is finalised.

Flexible ISAs

Rule changes have been made when it comes to how you can contribute and use the money in your ISAs.  Previously, if you withdrew money from an ISA, you could not put that money back into it without it counting towards your annual ISA subscription amount.

Now, you can take money out of your ISA at any point, providing it is a Flexible ISA, and replace it within the same tax year – this applies to historic ISAs as well as the one you are saving into for this tax year.

For example, if you have a flexible ISA, and you have contributed £15,000 of this tax year’s allowance, you still have £5,000 that you can add to the ISA within this tax year’s limits.  If you need to withdraw £5,000 in the meantime, you will be able to add that back into your flexible ISA, plus the remainder of this year’s allowance – so to £10,000 – as long as it is within the same tax year as the withdrawal.

Not all ISAs are flexible – it is up to the providers whether they offer this as part of their product or not and there are specific rules on how the withdrawals have to be transacted (withdrawals have to be transacted as cash, meaning that any investments held have to be sold first) – so you should check before you make any withdrawals to see what the rules are with your provider.

Portfolio ISAs

Whilst ordinarily you can only pay into one cash ISA per tax year, a small group of providers will allow you to open several different types of cash ISA with them.

For example, if you wanted to pay into a Help to Buy ISA, but also wanted to use the rest of your ISA allowance, some providers will also let you open, for example, an easy access cash ISA.  Other providers will allow you to open a mix of variable rate and fixed rate cash ISAs.

It is important to note that not every bank or building society will allow this, so check carefully with your chosen provider before proceeding, if you intend to make use of this feature.

Moving money between ISAs

If you have several different ISAs and you decide you want to move money between ISAs, we need to sound a note of caution: you must not close an ISA in an attempt to move money to a new one. Instead, you need to undertake an ISA Transfer if you are to maintain your tax benefits and annual contribution amount. 

Closing an ISA account ends the tax benefits for the money you held in that ISA, but transferring it to another ISA without closing the account is possible – and it is the only way to ensure you retain the tax benefits on that ISA money.  You should contact the ISA provider that you want to move your money to and ask them to start the process for you. They will contact your existing provider and get the ball rolling.  Not all ISA providers will accept transfers, so you need to make your choice carefully. 

What next for cash ISAs?

The end to the Cash ISA has been discussed for several years, as interest from both customers and providers has waned in recent years.  However there are still reasons to consider a Cash ISA for your savings.

The Personal Savings Allowance (PSA) was introduced in April 2016 and allowed Basic rate taxpayers to receive up to £1,000 in interest before you have to pay any tax on it and was a big reason as to why cash ISAs were no longer worthwhile. 

One thing is for sure though, it you had saved the maximum amount into a Cash ISA every year since their creation in 1999 and had only earned the Bank of England Base Rate (i.e. much lower than the best rates available), then you would still have ended up a today with a cash pot of more than £195,000; all in a tax free wrapper with the capacity to earn tax free interest.  If you had also invested the maximum into the ISAs predecessor, the Tax Exempt Special Savings Account (TESSA) and had rolled this into a cash ISA, you could have an additional £23,685.

At some point in the future the PSA could be removed or reduced, meaning having to pay tax on any savings outside an ISA.  And when interest rates eventually start to rise, the interest earnt on savings will increase and some might find that they start to exceed their PSA allowance.  In addition they could find themselves in a higher tax band and see their PSA reduce.  Either way it would be sensible to plan ahead and protect some cash now by placing it into an ISA, as there is an annual limit on what can be put in.

Alternative to Cash ISA

Many people view Cash ISAs as the only type of saving or investing that they are able to do, or they are concerned about the risk of putting their cash elsewhere.  While it’s important to keep a proportion of your wealth in a safe and easy to access place, such as a Cash ISA, its also important to understand the other options you have, as they may lead to great wealth.

Other options to consider include a Stocks and Shares ISA, Premium bonds or saving into a pension.

These are just some of a range of options that can help to boost your income and wealth.  Please get in touch for a no obligation chat about what options you may have.

Final Thoughts

The article has run through what ISAs are and also the main types of ISA.  For a more in depth look at the different types of ISAs please refer to our Different Types of ISAs article.  

If you have any further questions about ISAs, including which may work best for you, then please get in touch with a firm of Independent Financial Advisers such as ourselves who will be happy to offer you a free initial consultation to chat through any queries and what your next steps are.

Fill out our contact form and an adviser will call you back.

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