An Individual Savings Account (ISA) is a wrapper around a savings account or investment that has tax advantages.
What are the different types?
There are two types: a cash ISA or a stocks and shares ISA.
What is a cash ISA?
It is a savings account with the tax-free ISA “wrapper” placed around it so that you earn interest tax-free. Depending on the type of account you choose, you can have access to your money or tie it up until a future date – the latter tend to earn greater interest than the former – just like typical savings accounts.
They are considered low-risk as you will not lose your cash unless the savings provider goes bust – even then you’ll be protected by the Financial Services Compensation Scheme to the tune of £85,000 per person, per organISAtion.
What is a stocks and shares ISA?
A stocks and shares ISA is a stockmarket linked investment, where you wrap your tax-efficient ISA around an investment product such as shares, bonds, funds or investment trusts.
They are higher risk because investments can go down as well as up, meaning you could lose money. This is why they are better-suited to longer-term investors.
How much can I put in an ISA?
Every tax year you are entitled to a new ISA allowance. For 2013/14 this is £11,520. You can invest the whole amount in a stocks and shares ISA or you can split it by investing a maximum £5,760 in a cash ISA.
What are the tax advantages?
Interest is paid tax-free on a cash ISA, while any profits you make on a stocks and shares ISA are free of capital gains tax.
The income you receive from a stocks and shares ISA is a little more complicated. Although a 10% tax credit is automatically deducted, there is no further tax to pay on dividends.
This means that, while higher- and additional-rate taxpayers are better off in an ISA (as they would otherwise pay 32.5% or 42.5% respectively), basic-rate taxpayers would receive exactly the same amount of money whether their investment was inside or outside the ISA wrapper.
The exception is when income is derived from bonds or other fixed-interest investments, as this is classed as interest and paid tax-free in the same way interest is paid on a cash ISA.
What charges will I pay?
Cash ISAs tend to have no explicit charges – just like savings accounts – though you may face penalties if you withdraw cash from an ISA where you have agreed to tie your money up.
Charges on stocks and shares ISAs depend on your choice of account and how you invest the money. While you may be hit with an initial and an annual charge of between 0.5% and 5.5% on a fund-based ISA, if you have a self-select ISA (where you choose the assets you want to hold, rather than a fund manager making the decisions for you) you could face dealing charges and stamp duty on shares and an annual plan fee.
Can I transfer one ISA to another?
Yes, but you must stick to the rules. The simplest way to transfer is to ask your new ISA manager to do it for you. You'll need to complete an application form to open an ISA with it as well as a transfer request form. It will then contact your existing ISA manager and arrange for the funds to be transferred to your new ISA.
You also need to abide by the rules on what you can transfer. While you can shift all or some of a previous year's ISA allowance, because you can only have one cash and one stocks and shares ISA in the current tax year, you must move all of it.
It's also possible to transfer your cash ISA to a stocks and shares ISA if you decide this is a better home for the money. The transfer process is exactly the same but do remember that once in stocks and shares you can't switch the money back to a cash ISA.
Who can have an ISA?
Any UK resident can open a cash ISA from the age of 16 and a stocks and shares ISA from the age of 18.
Where can I get one?
You can walk straight into a bank or building society branch and open an ISA, or open one over the phone or online if the provider allows.
You can also buy a stocks and shares ISA direct from a fund management company or via a broker or fund platform. You’ll need proof of identity such as a passport or utility bill.
What should I use my ISA for?
You can treat it merely as a tax efficient savings account, should you wish. But you’ll earn more money if you lock your savings away for more than a year (the longer you invest it, the higher the rate).
But many people invest in the stocks and shares version in order to generate a better return. You can invest in most types of investment including: shares listed on recognized global stock exchanges; UK and European gilts; corporate bonds; investment trusts; funds; and exchange traded funds.
This makes them ideal for longer term savings goals such as boosting your retirement income.