Savings account Guides

ISAs - an introduction

Updated: Wednesday 11 April, 2012

By Martin Fagan

With tax-free savings, an ISA should be the first place you stash your cash.

It may only constitute three letters, but the importance of an ISA as a means of tax-free savings cannot be overstated.

ISAs offer tax advantages to everyone in the UK and, over the years, the government has simplified them considerably, making ISAs more accessible to a larger number of savers and investors.

Understanding ISAs is the first step to reaping the benefits of tax-free savings.

What are ISAs?

The acronym stands for Individual Savings Account. Although the term “ISA” is often used to describe a financial product (cash ISA, for example), an ISA is actually a tax-free wrapper in which you place savings or investments. Think of it like this: if you went and bought a pair of shoes and the shop gave you a free carrier bag in which to put them, the shoes are the investment and the carrier bag is the ISA.

There are two types of ISA, cash ISAs and stocks and shares ISAs:

A cash ISA is one of the simplest products on the financial market. It is basically a savings account wrapped in an ISA that allows you to save money without having to pay any tax on the interest you earn.

A stocks and shares ISA is used to protect your investments from taxation, chiefly Capital Gains tax (CGT) levied on any rise in value of an investment.

You can pay into one or both types during the tax year to prescribed limits, and there are limits to how much you can save or invest each year.

Who can have an ISA?

To open an ISA you must be:

• A UK resident (or a Crown employee serving overseas or married to such an employee)
• Aged over 16 for a cash ISA and over 18 for a stocks and shares ISA.

How much can I save in an ISA?

For the current tax year 2012/13, your ISA allowance is as follows:

• Your combined investment (in a cash ISA and stocks and shares ISA) can be up to £11,280
• You can invest up to £5,640 of this balance in a cash ISA and the remaining balance of £5,640 into a stocks and shares ISA
• You can invest the whole year’s allowance of £11,280 in a stocks and shares ISA

These allowances leave you with three options:

• Fill your cash ISA to the max - You could use the full cash allowance and invest £5,640 in cash (leaving you with the option to invest up to £5,640 in stocks and shares)
• Put it all in shares - If you don’t want a cash ISA at all, you can invest the full £11,280 in stocks and shares
• Make the most of ISA flexibility - If you invest less than £5,640 in cash, (for example, if you only invest £1,000 in cash) you can invest the entire remaining balance (in this case £10,280) in shares.

Finding an ISA

Cash ISAs are offered by banks, building societies and National Savings & Investments. To ensure you are getting the best rate, it’s crucial to compare ISA deals and read the terms and conditions of the account.

You can only have a cash ISA with one provider in any tax year, which means you can’t split your allowance between accountsaccounts and providers. However, you don’t have to save with the same provider every tax year, so you can hold cash ISAs from different providers in different tax years.

There are several routes you can go through to buy shares ISAs, including buying directly from a fund manager or through an independent financial adviser (IFA). More information on this can be found in our guide to shares ISAs.

To open an ISA, you will normally need to show some form of identification, such as your passport or driving licence, and also proof of address for which you’ll need a utilities bill or bank statement in your name.

When to open an ISA

The tax year runs from 6 April of one year to 5 April the following year. You get a new ISA allowance each tax year and it’s a good idea to use as much of your allowance as you can within that time. If you don’t use it, you lose it - unused allowances don’t roll over to the next tax year.

However, once you have put money into your ISA, you can keep it in there, earning tax-free interest, for as long as you like. This means it’s possible to accumulate substantial amounts in ISAs over the years.

You can pay money into your ISA at any time of the year but many people do leave it to the last minute, making March a busy month for ISA sales.

Ideally, to earn the maximum amount on interest on it, you should park as much cash as you can in your ISA at the beginning of the tax year.

However, you should also consider when whether you might need access to your cash as money withdrawn cannot be re-invested once you have used up your annual allowance.

Withdrawals

Many easy access cash ISAs will allow you to withdraw you money at any time without penalties.

However, you should think twice before making withdrawals.

Any money withdrawn from a cash ISA or stocks and shares ISA cannot be returned to top it back up. You can only pay in your set allowance each year, regardless of how much you withdraw.

For example, if you put £4,000 in your cash ISA, you could still add a further £1,640 to it before the end of that particular tax year. If you invested £4,000 at the start of the tax year and withdraw £1,000 later in the year, you would still only be able to put a further £1,640 in, making your total ISA balance for the year £4,640.

If you put the full £5,640 in your cash ISA at the start of the year and then withdrew half of it later, you would not be able to pay in any more until the next tax year.

Having said this, if you don’t think you are likely to pay in more than £5,640 over the year, making withdrawals isn’t such an issue.

Next Tax Year's ISA Limits (2013-2014)

The annual ISA allowance will increase in the new tax year (6 April 2013 - 5 April 2014). The annual increase will be based on the rise in the Consumer Prices Index (CPI) and will be announced in the next Budget, which is pencilled in for March 2013.

On a ghoulish note...

The tax benefits of all your ISA assets - be they cash or stocks and shares - will cease on death. There will be no tax to pay on any interest, income or capital gains up to that date but your next of kin will have to account for tax on any income or gains arising after your death.

All the savings previously wrapped in ISAs will be added to your estate (property, other investments/savings and assets such as furniture, vehicles, etc.), which will then be assessed for inheritance tax (IHT).

If your estate is valued at over £325,000 - the current IHT allowance which is frozen until 2015 - your next of kin will have to pay 40% on anything above this limit.

Download our complete guide to ISAs >>>

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