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ISAs 101: Save And Invest Tax Free

ISAs for tax efficient saving and investing

ISA stands for Individual Savings Account. It is a type of account available to UK residents aged 18 and over (16 for cash ISAs). They allows savings and/or investments to be held free from any UK taxes.

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Each person can currently contribute a maximum of £20,000 per tax year to an ISA. Any of this allowance not used cannot be rolled over into the next tax year. An ISA is effectively a tax wrapper so anything held inside of them is free from any taxes. These rules could be amended by the government in future. There are currently 5 different types of ISA account you can hold and we will explain each one below.

Cash ISAs

Cash ISAs are one of the most popular savings products. They are basically just a cash savings account but any interest earned on your money is free from tax. Although within an ISA your savings are free from income tax, in the current low interest rate environment this type of account is mostly redundant as most people wouldn’t exceed their personal savings allowance.

Your Personal Savings Allowance is the amount of savings interest you can earn before you have to pay income tax on it. This allowance differs depending on which income tax band you are in. Put simply, if you are a basic rate tax payer you can earn up to £1000 in interest per year before you begin to pay tax on it. You can see the full list of allowances on GOV.UK.

Interest Rates

At the time of writing this post the average UK easy access savings account interest rate is just 0.17%. The average UK saver has around £6700 in savings. So after 1 year this would only amount to £11.39 earned in interest – well below the £1000 threshold. Also good to remember is that with interest rates below the rate of inflation this will erode the value of your cash over time.

It is good practice to have some cash set aside. But if you have a large amount of spare cash that is not required in the short term you are likely to achieve better returns with a Stocks and Shares ISA or Innovative Finance ISA listed below.

Tax efficient ISAs for savings and investments
Tax efficient ISAs for savings and investments

Stocks & Shares ISAs

With a Stocks and Shares ISA you can invest in things such as shares, bonds, funds and ETFs. These are usually best if you want to grow your money over the longer term. It is free from any capital gains tax and income tax.

If you hold investments outside of an ISA that pay dividends, then the first £2000 of dividend income is tax free. However, you would start to pay income tax on any amount over this limit. You may also have to pay capital gains tax on large profits when selling an investment. If you hold your investments within an ISA then you do not pay any of these taxes.

Interested in investing? Then you may like to read this post; what are the different types of dividends?

Stocks and shares ISAs
Stocks and shares ISAs

Innovative Finance ISAs

Innovative Finance ISAs are a relatively new type of ISA account that let you hold Peer-to-Peer investments. These types of investments usually offer much better returns than cash ISAs but they do carry a little more risk.

Peer-to-Peer lending platforms are not currently regulated by the FCA (Financial Conduct Authority). So if a platform were to go bust you may not have any protection. As with other ISAs, these are free from any income and capital gains taxes.

Lifetime ISAs

Lifetime ISAs are available to anybody aged 18-39 to use to save for a deposit on a first home or saving for retirement. The Lifetime ISA is a successor to the now closed Help to Buy ISA.

There is an annual limit of £4000 which you can contribute each tax year. The government will contribute 25% of the value each year. So for example if you pay in the maximum £4000 you will receive £1000 government bonus. You can hold this as either cash or invest in stocks and shares. Again all money is free from income tax and capital gains tax.

Because this type of ISA is designed to help young people get onto the property ladder or save for retirement it is important to note that there are limits on withdrawals. You can only withdraw free when the money is used towards a deposit on your first home.

Or you can withdraw it when you reach the age of 60 or in cases of terminal illness. Otherwise if you wish to withdraw your money it is subject to a 25% withdrawal charge.

Junior ISA

The final type is a Junior ISA. Now if you are an adult this isn’t one you can open for yourself. But you can open one for a child under 18 if you are their parent or legal guardian. When the child turns 18 they then get access to it.

There are actually 2 types of Junior ISA – Cash Junior ISA and Stocks and Shares Junior ISA. Both types of account can be opened in the same tax year and the maximum allowance of £9000 can be split between them.

As the account is opened in your child’s name it is legally their account. You are not able to access the money in this unless in certain exceptional circumstances. Any contributions you make to a Junior ISA doesn’t count towards your own annual ISA limit.

Junior stocks and shares ISAs for your child's future
Junior stocks and shares ISAs for your child’s future

Opening And Operating ISAs

If you wish you can open up one of each type of ISA within the same tax year. But the annual allowance of £20,000 has to be split between them. So for example you could put £4000 into a Lifetime ISA, £6000 into a Stocks and Shares ISA, £5000 into an Innovative Finance ISA and £5000 into a Cash ISA. Which would total £20,000. You then wouldn’t be able to add any more money to these until the start of the next tax year.

You can also only open one of each type of ISA per tax year. So for example you cannot open 2 Cash ISAs within the same tax year. If you have to complete a tax return then you don’t need to declare any interest, income or capital gains that are part of an ISA.

With the exception of a Lifetime ISA you are free to withdraw your money if you need to. However it is important to note that even though it has been withdrawn it still counts towards your overall annual allowance and cannot be replaced.

For example say you have maximized your £20,000 allowance in a cash ISA and then withdraw £5000. You cannot then pay back in £5000 in the same tax year as you already reached your limit. You would need to wait until the new tax year. When your new allowance starts in the next tax year you can continue to contribute to an account you already have set up or open a new one. The choice is yours.

Transferring An ISA

ISAs can be transferred to different providers and this doesn’t count towards your allowance. You might want to do this to take advantage of better savings rates or to combine separate ISAs into one. One ISA type can usually be transferred to another type. For example from a Cash ISA to a Stocks and Shares ISA.

Hopefully this has cleared up what ISAs are and how you can use them for tax efficient saving and investing. View our blog for more posts covering finance and investing and join our newsletter for the latest content.

If you are a UK investor you may also like to read our post about PrimaryBid. This platform helps connect listed companies with smaller investors when raising capital.

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