Why should you make use of an ISA?

Last Updated on 22 February 2023 by Dan

Hello everyone! When investigating options for your finances, you may frequently see reference to something called an ISA, usually with encouragement to make use of it. However, what an ISA is and does is rarely well explained.

Today we’re going to demystify this and explain why an ISA can be incredibly beneficial to your financial health!

As ever – our normal note that we take care with what we write on this site but it is not official “financial advice” and whatever investments and savings you enter need to be right for your circumstances. We always suggest doing your own further research. If you’re in doubt about anything, it’s worth consulting a regulated and reputable financial advisor who can provide tailored advice built for you. Unbiased is a resource that can help you match with an advisor who matches your needs.

What is an ISA?

ISA stands for an Individual Savings Account.

There are multiple different types of ISA available which we’ll go into below, however they all follow the same principle of acting as a scheme by which the Government encourages us to save or invest without the gains (such as the interest or dividends) being exempt from tax.

What is the advantages of an ISA?

With most savings and investments, making gains beyond some allowances (more on those in this article) will result in you being judged to have made a taxable gain. These vary depending what exactly the source of the income you’re receiving in.

The Government will allow you to save or invest up to £20,000 per year in an ISA wrapper however. When in this, any capital gains or dividends on investments within the ISA are exempt from tax.

This is incredibly beneficial and generous – by investing or saving in ISA’s each year to make use of the allowance, you can end up with a substantial pool of investments that won’t attract tax.

What types of ISA are available?

There are four core types of ISA:

Cash ISA

A cash ISA is the most simple form of this product, albeit probably the least useful to most people.

A cash ISA is basically very similar to a savings account at the bank, except if it’s in an ISA rather than a regular bank account, you don’t pay any taxes on the interest than you earn.

Now in practice everyone has a personal savings allowance which lets them rack up £1,000 of interest without incurring tax, or £500 of allowance if you’re a higher rate tax payer. (No allowance for additional rate tax payer).

Over this, your savings will start getting taxed at your personal income tax rate – at 40% or 45%, that’s quite a lot of gain eradicated.

Where the Cash ISA option can be useful is that going down the ISA route can provide a slightly wider selection of interest bearing accounts, which can but does not always provide a better rate of interest than a regular savings account.

Cash ISA’s have come back into more focus in a world of higher interest rates, given with better savings rates more people are potentially being subject to take on savings.

Stocks and Shares ISA

Instead of saving cash, as the name implies a Stocks and Shares ISA will let you buy investments in either companies or funds.

With this, you’re getting into investing which also carries risk (see our guide to the characteristics of various investments and also to understanding your investment risk profile).

So what’s the advantage? Well you can end up incurring taxes on investments in a couple of ways:

If you sell investments and you’ve made a substantial capital gain via selling the shares at more than you bought them for. This is becoming increasingly important as capital gains tax allowances are being reduced over the next couple of years.

Or

You could be charged tax on dividends, which are payments made to you by the company you own stock in as part of the incentive to you to hold those shares. The dividend tax allowance is also being reduced over the next couple of years.

Now your first thought may be that those figures sound quite a lot, and is it really worth it for the bother of setting up an ISA? It really is:

For the capital gains side, the tax is not charged where you’d make that gain in a single year – it’s charged when you’re selling the investment and thus the profit becomes realised.

As a result (hopefully) at the point you’re selling it your investments will have benefited from multiple years of saving, growth and compounding – and you can end up hitting the allowance figure more quickly than you’d like. You can read here about compounding and how it works.

The specific amount of tax you save through an ISA will be dependent on your specific circumstances, tax band and allowance, but can be up to 20% of the chargeable portion of a capital gain, or 38.1% of the chargeable portion of dividend gains.

The Koody website also has a guide to stocks and shares ISA providers and their associated costs and charges.

Lifetime ISA

A lifetime ISA is designed to enable you to either get a bonus in saving either for a first home or for retirement, with the Government giving you a immediate extra 25% on top on the savings involved with a maximum of £4,000 each year. Now this sounds absolutely great (free £1,000 a year) but in practice there’s quite a few strings. You can use the allowance either to put in cash or stocks and shares.

Firstly is that if you don’t use the money for it’s intended purpose the extra 25% of benefit is immediately withdrawn, as you might expect.

Let’s divide those into the two options:

Retirement LISA

The issue with the retirement route is that it sounds a good top up when you compare it to the tax relief you’d get on a private pension it’s not that beneficial.

This is because you automatically get tax relief on your pension contributions and can usually salary sacrifice them for additional benefit, meaning that for anyone who isn’t a self-employed basic rate taxpayer you are highly likely to be better off simply putting the money directly into your pension as the tax save is likely to be bigger than the 25%.

(And you can read about why we always advocate maximising pension savings here).

The First Home LISA:

A LISA can be a better route if you’re buying a first home, but you need to make sure you fit into the eligibility criteria, of which the main points are:

• You cannot previously have owned a home (anywhere in the world, not just in the UK).
• You need to be 18-39 years old.
• The property you’re looking at buying must be £450k or less (which can be a consideration if living in London or the South East).
• You need to have the LISA open for at least a year to be able to use it for a home.

Innovative Finance ISA

An innovative finance ISA contains a different type of investment to standard stocks and shares but allowing you to use your money for peer-to-peer (P2P) lending – I.E you’re effectively making a loan to a business for a rate of interest.

This section of the market has seen some very high rates of return, but can also be extremely risky. If the company that you lend your money to goes under, you can lose your whole investment.

So it’s really essential that you know what you’re doing here and don’t simply chase glitzy return numbers. We’re smart investors and we know that rates of return are usually correlated with risk. As the investor, you want to be sure that the return is appropriate for the level of risk you’re taking and that you’re happy with that level of risk.

That’s not easy. Unless you have a level of technical knowledge where you can comfortably read through a set of financial statements and have a detailed understanding of the financial health of whoever you lend to, I’d personally tread with great caution in this space, particularly given the uncertain outlook for many businesses this year.

You also don’t have great liquidity on your investments – so if you’d want to be able to get money out in an emergency situation , that’s not always possible with peer-to-peer lending.

You also want to be careful the company you’re doing the peer-to-peer lending through doesn’t go bust – your contract is usually technically with the company you’ve done the loan to, but collapse of the arranger can lead to legal complications in terms of how the arrangement works.

Finally, there are some restrictions on how much investors who are new to peer-to-peer investing can put in – 10% of your investable income.

(You can probably tell by the amount of warnings here that I think most are best avoiding this route!)

How do I save in an ISA?

How you save in an ISA depends on what type of ISA you’re looking for. Just make sure you do your research and whoever you’re transferring money to is real and reputable.

If looking to open a Cash ISA, most banks will offer this, and it’s worth taking a look at best buy tables to check you’re getting the best rate.

If you’re after a Stocks and Shares ISA, check investment providers. Options such as Hargreaves Lansdowne offer relatively simple options for ISA investors, and I’m a fan of index fund providers like Vanguard who I use. Simon from Financial Expert also as a wider guide to available stockbrokers.

If you’re looking to open a Lifetime ISA, it’s the same as the Cash ISA or Stocks and Shares ISA depending on if you want to use the ISA for cash or investments.

If you’re after a Innovative Finance ISA, you need to be especially careful about researching the provider given the warnings above on the arranger going bust – it’s probably best to go with a more established name like Funding Circle.

How much can I save in an ISA?

You can save up to £20,000 in ISA’s in the 2021/22 tax year in a single ISA or a combination thereof provided you don’t go the total value.

For instance, it’s equally permissible to have:

£10,000 in a stocks and shares ISA, £5,000 in a cash ISA and £5,000 in an innovative finance ISA – total £20,000.

OR

You could simply have £20,000 in a stocks and shares ISA and max out the total that way.

You cannot have multiple types of the same ISA with different providers – I.E a stocks and shares ISA with Hargreaves Landsdowne and another with Vanguard.

The only other limit you need to consider is that you can only put £4,000 into the lifetime ISA option per year (and can still distribute the £16,000 elsewhere).

Questions?

ISA’s have a tendency to confuse people which is a shame given the benefits on offer, so if you do have any further questions just use our comments box below to ask.

And that’s it!

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