An ISA stands for Individual Savings Account. It’s a specific type of account that allows you to either save or invest a set amount of money each year. What makes this account different from other investment tools, however, is that you’ll never ever have to pay a single penny of taxes on any investment returns with an ISA which makes this a popular investment option amongst people who are starting to invest for the first time.
Sounds great, doesn’t it? And it certainly is. But, you probably noticed how ‘penny’ was used instead of ‘cent’, didn’t you?
That’s because an ISA is specific to the UK only. It’s not like there aren’t similar investment or savings tools available around the globe at any given time. The Roth IRA, for example, lets taxpayers in the US enjoy tax-free withdrawals, as well. However, the total amount you can contribute to a Roth IRA per year is only $6,000 ($7,000 if you’re over the age of 50). Roth IRAs also have a maximum threshold of income level – anyone earning over $144,000 yearly would not be eligible.
While there are other tax-favourable savings schemes and investment options available, typically, however, these financial tools usually don’t possess as favourable a tax status as ISAs do.
Types of ISA
ISA as a savings and investment tool was introduced more than 20 years ago, in 1999. It replaced similar tax-advantaged savings tools. As of 2017, there are four types of ISA available:
A cash ISA is quite similar to a regular savings account in that you deposit your cash and can earn interest upon your deposit. The advantage of an ISA is that you’ll never have to pay tax on your deposit and any interest. There are two types of cash ISAs: variable and set rate. With variable rate cash ISA, you can deposit your money and then access it at any moment you deem necessary, however, the interest rate may fluctuate during the deposit period. With a set rate cash ISA, your interest rate will stay level, which can prove to be more fruitful in the long term. However, there may be a penalty if you decide to withdraw your funds pre-term.
Stocks and shares ISA
A stocks and shares ISA allows you to invest your funds into various investment tools, like stocks, shares, bonds and trusts. Typically, you would set up an account with an ISA provider, which would then let you pick between a readily made product and a custom portfolio. This way, if you have particular requirements and predispositions on where you want to invest – the stocks and shares ISA is still flexible enough as an investment vehicle.
Innovative Finance ISA or IFISA
As with the stocks and shares ISA, the Innovative Finance ISA is also an investment ISA. But, instead of investing your funds into the stock market, you would invest into peer-to-peer lending. The provider, you choose, will take your money and invest it into peer-to-peer loans of your liking. It’s also important to note that various providers may or may not provide various forms of investment protections, but an IFISA IS NOT protected by the Financial Services Compensation Scheme (FSCS), as opposed to a cash ISA.
A Lifetime Isa or LISA, as we’ll lovingly refer to it, is one of the more interesting types of ISAs. This is mainly because there’s a bonus component in how a LISA works. Unlike with other ISA types, you can only contribute £4,000 out of your £20,000 yearly allowance to a LISA. However, the state will match 25% of your annual contributions. Therefore, you can save up to £5,000 each year in a LISA, before interest. There are age limitations for opening a LISA and benefiting from the annual state bonus, as you can only open one between the ages of 18 and 39, and you can only receive the state bonus up until the age of 50. Yet, you can continue earning interest on the funds in your LISA after turning 50.
All four ISA types have a £20,000 contribution limit as of the 2020/21 tax year. This means that you can either use all the aforementioned amount for one of the ISA options, or you can split it up between two or more ISA options. For example, if you choose to invest £5,000 in a cash ISA, you would still have £15,000 available for you to spread between the other ISAs. The £20,000 yearly tax-free allowance, however, is not transferable year-to-year. If you don’t use it all or at all, the amount will be lost at the end of the tax period.
Also, important to note is that if you withdraw your funds from any of your ISAs during the tax period, you may not deposit them into a new ISA of the same type, as this transaction will count towards your tax allowance. If you want to switch ISAs, it’s better to do it via transfer, which is a service most providers will offer, after you fill out a transfer form.
Additionally, Junior ISAs are available for UK residents under the age of 18. Junior ISAs are available in both the cash and stocks and shares types, however, they have a reduced contribution limit of £9,000.
Using any type of ISA as a savings and investment vehicle can be a good idea. The tax wrapper would help you optimise your savings rate, therefore helping you build your wealth faster. By using this tax-efficient tool, you’ll be able to earn more on the typical cash deposit or stock market, than you would without the help of an ISA.
If you’re looking to purchase a home, a Lifetime ISA would help you tremendously on your journey to save up for the first deposit. The same goes for a retirement cushion. With the annual government 25% bonus you’ll receive on top of your deposit, the funds will grow much quicker. And that’s even before the interest starts trickling back in.
It is up to you to decide which ISA to opt in to as well as how much money you should deposit. Remember, though, that in order to maximise your savings rate and grow your wealth quicker – it’s always worthwhile to use all your tax privileges. And, to our UK readers, ISAs are definitely a privilege.
This is an informative blog entry and should not be taken as financial advice.