Savings are a big topic right now, with financially hit savers further impacted by record low interest rates. One of the most popular savings options out there is the Individual Savings Account, or ISA.
What is an ISA?
An ISA is a savings account that offers you an easy, tax-efficient way to save or invest your money. They were originally introduced by the government in 1999 and are designed to encourage those over the age of 16 to save or invest for their or their children’s future.
There are several advantages to these kinds of accounts. Firstly, you pay no tax on the interest you earn, nor on any increase in the value of your investments (i.e. no Capital Gains Tax). Secondly, some also deliver a government bonus, depending what ISA you select.
What types of ISA are there?
Below, we’ve outlined the different types of ISA available:
Cash ISAs are basic savings accounts, but you never need to pay tax on the interest you earn on your money.
Stocks and Shares ISAs allow you to make investments without having to pay Capital Gains Tax on your returns or tax on dividend income. ISA dividends have no impact on the dividend allowance.
Junior ISAs (or JISAs) are specifically designed for children under the age of 18, allowing them to build up their savings in a tax-efficient way. The money can either be held in cash or invested in stocks and shares – or a mixture of the two.
Help-to-Buy ISAs are specifically aimed at those looking to purchase their first home. It is a type of cash ISA that delivers a government bonus of 25% (up to a ceiling of £3,000) if the money is used to complete a house purchase. Although the Help-to-Buy ISA closed to new customers on 30 November 2019, existing savers will be able to continue saving money into their account until November 2029.
Lifetime ISAs (or LISAs) are a newer introduction designed for those between the ages of 18 and 40 looking to save for their first home or for retirement. The money you save can either be held in cash or invested in stocks and shares. It can be attractive because, while savers have to open their account before the age of 40, it allows them to contribute and receive their yearly bonus until they are 50.
Innovative Finance ISAs (or IFISAs) allow you to lend money through peer-to-peer lending platforms. Peer-to-peer lending matches up investors willing to lend with borrowers, who could be, for example, individuals, businesses or property developers. Any interest earned within your tax-free wrapper will not be taxed and will not count towards your Personal Savings Allowance.
How much can I save into an ISA?
For the 2020-21 tax year, you are allowed to save a generous £20,000. You can put the entire £20,000 into a Cash ISA, or invest the full amount in a Stocks and Shares ISA. You can also mix and match and split the allowance between various types of ISA – Stocks and Shares, Cash (including Help- to-Buy), Innovative Finance and Lifetime, as long as you don’t exceed the annual allowance.
You can only put £4,000 in the Lifetime ISA each tax year, so you could put the remaining £16,000 into any of the other ISA options.
For Junior ISAs, the allowance went up significantly for the 2020-21 tax year, meaning that children can now save up to £9,000 into an ISA.
Lifetime ISAs allow adults between the ages of 18 and 40 to save up to £4,000 per tax year (included within your £20,000 allowance), on top of which the government will pay a 25% bonus. This means that people who save the maximum amount annually will receive a £1,000 bonus from the government each year. However, savers should also be aware of the risks associated with LISAs, including early withdrawal charges, restrictions and accessibility.
What is best – Cash or Stocks and Shares?
There are advantages and disadvantages to both options. For example, there is less risk associated with a Cash ISA as you are guaranteed to get all your money back. Some Cash ISAs also offer instant access to your savings, so they might be a better option if you think you will need to withdraw your money. However, with interest rates currently at rock bottom due to the coronavirus crisis, you risk inflation eroding the value of the money you have saved over time.
With a Stocks and Shares ISA on the other hand, the money you invest will rise and fall according to fluctuations in financial markets. This may seem riskier, but Stocks and Shares ISAs have historically offered a higher rate of return than Cash ISAs.
On the downside, you are likely to have to lock away your money for longer (a minimum of five years, for example) to see the benefits, which may not suit you if you think you will need access to your money before then.
Can I withdraw money from my ISA?
With Cash ISAs, this entirely depends on the type of account you have chosen. For example, there are instant access Cash ISAs available that allow you to withdraw your money with no restrictions. However, with a fixed rate (or fixed term) Cash ISA, you have to lock your money away for a certain period of time in return for higher interest rates. If you withdraw your money earlier, you could be subject to penalties.
Finally, under new rules introduced in April 2016, flexible Cash ISAs allow you to withdraw money from your account and replace it within the same tax year, without it affecting your current annual allowance. Always check the terms of your ISA before withdrawing money.
You can withdraw money from a Stocks and Shares ISA at any time - but there is always the risk that the value of your investment may have gone down at the time you need to withdraw it, meaning you could get back less than you originally invested. You should also be aware that, if you withdraw money from your Stocks and Shares ISA, you can only reinvest it as part of your unused annual allowance.
It is more costly to withdraw money from a LISA, as these are designed to help you save up for specific life events, e.g. buying a first home or saving for retirement. Therefore, the penalties for withdrawing your money before the age of 60 (unless for the specific purpose of completing a property purchase) are hefty to deter savers from doing it.
If you want to withdraw money, you’ll have to pay a 25% withdrawal fee* on the money you take out (i.e. the amount you have accumulated in government bonuses), although this doesn’t apply in the first year of the scheme. So, if you had £10,000 saved, you would only get £7,500 back. That’s why LISAs aren’t right for everyone.
What type of ISA is best for me?
This entirely depends on your goals and what you are saving for. The right ISA for you will also depend on your risk profile and time scale.
If you’re simply looking for an account that will allow you to save tax-efficiently and access your savings when you need to, then a Cash ISA will probably be your best option.
If you’re happy to invest for the longer term, you may want to consider a stocks and shares ISA. If you are saving for a home and do not yet have an ISA, then a LISA could fit the bill. If you're looking to save as much as possible for retirement, then a LISA is definitely worth considering, however your pension should be top priority for retirement saving.
Whatever your financial goals are, we are here to help. At Tees we provide independent financial advice, working in partnership with you for the long term, always there when you need us.
*Due to the coronavirus crisis, the withdrawal fee has temporarily been reduced to 20% until 5 April 2021.