Admittedly, Individual Savings Accounts (ISAs) aren’t very exciting, but they do offer one of the best tax breaks available to anyone looking to build substantial capital. And the terms are surprisingly generous, too. As with every financial product these days, there are some layers of complexity that make it hard to work out whether an ISA is right for you. In this post, I’ll explain how ISAs work and outline the potential benefits of using them to save cash.
What is an ISA?
An ISA is a tax-free wrapper, so it allows you to wrap your savings and protect them from tax. If you have substantial savings, or you’re a higher-rate taxpayer, this provides a significant benefit. You can invest up to £20,000 each year in some ISAs without paying any tax on the interest or income you receive.
There are currently six types of ISA:
- Cash ISA
- Stocks & Shares ISA
- Innovative Finance ISA
- Lifetime ISA (available only to people aged under 40)
- Help to Buy ISA (set to end in November 2019)
- Junior ISA (available only to children under 18)
They all work differently, so I’ll be dedicating separate blog posts to each type. You can save a maximum of £20,000 across Cash, Stocks & Shares, and Innovative Finance ISAs – so you could put £10,000 in cash, and £5,000 each in the other two.1 You can’t contribute to the same type of ISA with multiple providers within the same tax year, though. For example, if you wanted to divide your cash between two banks, you’d need to stop paying into the first by 5th April, then contribute to the other from 6th April. The money in the first bank will continue to grow, but you won’t be able to add to it.
If you build a monster ISA, it might be worth spreading it across different institutions to balance the risk. The Financial Services Compensation Scheme (FSCS) protects cash savings up to £85,000 per institution, and investments in an ISA up to £50,000. Innovative Finance ISAs are not covered by the FSCS.
Is it worth having a Cash ISA?
Among the ISA family, the cash ISA is the least exciting member. It works just like a traditional savings account, but you don’t pay tax on the interest you receive. This isn’t likely to be an advantage unless you have accumulated over £50,000, as basic-rate taxpayers can currently earn £1,000 interest each year before they’re liable for tax.2 But there are other reasons why a cash ISA is sometimes appropriate.
As I mentioned in an earlier post, cash is not a good option for long-term savings. Inflation is likely to eat away your capital, especially in periods marked by low interest rates. A cash ISA can be useful, though, for saving storing large sums of money in the short term, for example:
- You’ve sold your house and need to stash some of the equity temporarily and safely before buying another property.
- You’ve inherited some money and are deciding what to do with it.
- You’re saving for a major expense, such as a loft conversion or a house deposit (If you’re under 40, a Lifetime ISA could be a better option for the deposit; if you’re over 40, a Help to Buy ISA might be appropriate)
You should check the terms and conditions of any cash ISA you’re considering to ensure it’s suitable in terms of accessibility – some will lock away your money for a fixed period to guarantee a higher interest rate. A few providers offer flexible ISAs. This means you can withdraw the money and then replace it later without affecting your maximum contribution.3
A Cash ISA can be right for some people – it all depends on your circumstances and goals. It’s generally not a good idea when you need long-term growth, such as for retirement savings. In that instance, you could be better off with a Stocks & Shares ISA, the subject of my next post. Indeed, putting money in a Cash ISA reduces how much you can invest in a Stocks & Shares ISA, so don’t waste your allowance unnecessarily. If you want to stick with cash for now, take a look at MoneySavingExpert’s top deals and FAQs. Otherwise, stay tuned to meet the other members of the ISA family.
- There are lower limits for Lifetime, Help to Buy, and Junior ISAs. [↩]
- The threshold for higher-rate taxpayers is £500. If the interest you received exceeds the threshold, you need to declare the amount through your tax return and pay the amount stated. Basic-rate tax is no longer automatically deducted by banks and building societies. [↩]
- If you deposited £20K and subsequently withdrew £10K, some providers wouldn’t let you replace it later, as that would mean you’d deposited £30K over the year. [↩]