What is an ISA?

ISAs offer you a flexible way to save or invest without paying any tax on the interest or profits you earn. Our simple guide explains the basics of how they work, what types of ISA are available and how ISAs compare with other savings accounts.

ISAs offer you a flexible way to save or invest without paying any tax on the interest or profits you earn. Our simple guide explains the basics of how they work, what types of ISA are available and how ISAs compare with other savings accounts.

Anelda Knoesen
From the Money team
minute read
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Posted 12 JANUARY 2021

What is an ISA?

ISA stands for individual savings account. Put simply, it’s a savings or investment account that you never pay tax on.

There are limits set by the government on how much you can save or invest into an ISA account in the UK each year. This is called your ‘ISA allowance’, and the exact amount can change each tax year.

ISAs are offered by a range of financial institutions, including banks, building societies, the Post Office, insurance providers, stockbrokers and peer-to-peer lenders.

How do ISAs work?

Your money can’t be taxed when it is in an ISA, no matter how long you keep it in there.

You’ll get a new ISA allowance at the start of every tax year. This is how much you can pay into an ISA. For the tax year 2020/21, the maximum amount you can put in is £20,000. The tax year runs from 6 April to 5 April.

If you don’t use all your ISA allowance before the end of the tax year, you’ll lose it forever. You can’t roll it over to the next year.

To open an ISA, you’ll need to be at least 16 years old and a UK resident. You can set up an ISA account online, in-branch, by post or over the phone, depending on which product you choose.

You can have more than one ISA, but the allowance applies across the total of all accounts. You can put the full £20,000 into just one account or split it across various types of ISA. You cannot pay into two ISAs of the same type in the same tax year.

What types of ISA are there?

ISAs come in different forms and can help you save for different things, such as a home, for retirement or for your children’s future. Here’s a quick breakdown of the types of ISA you can get.

What is a cash ISA?

A cash ISA is much like a regular savings account, except that the interest earned is never taxed. The minimum amount you’ll have to deposit to open your account can vary from £1 up to £1,000.

Interest rates vary between providers and you can choose between:

  • an instant-access cash ISA – you can pay in and take out money as often as you like, although some ISA accounts do have limits on this. The interest rate is usually variable, which means it can go up or down.
  • a fixed-rate cash ISA – you deposit money and agree to lock it away for a fixed length of time, five years, for example. Generally, the longer you tie up your money, the higher rate of interest you’ll earn. There are usually penalties if you try to access your money before the end of the fixed-rate period.

You must be aged 16 or over to open a cash ISA savings account, and you’re only allowed to pay into one cash ISA in each tax year. You can transfer an existing cash ISA to a new provider at any time without losing your tax-free benefits. To keep the tax-free status of your money, you’ll need to contact your new provider and arrange a transfer, rather than withdrawing the money and opening a new account.

What is a Lifetime ISA?

A Lifetime ISA is available to anyone aged 18 to 39. You can use it to buy your first home or save for your retirement.

You can save up to £4,000 a year until the age of 50, and you’ll receive a 25% bonus from the government on top of what you pay in. Potentially, that could give you an extra £1,000 a year.

There’s a penalty to pay, though, if you withdraw the money before your 60th birthday or you don’t use it to buy a house.

What other types of ISA are there?

Compare the Market currently only offers comparisons for cash and Lifetime ISAs, but there are other types of ISA available.

  • Stocks and shares ISAs give anyone over the age of 18 the chance to invest in the stock market through funds, bonds and individual shares. You’ll usually need to invest a minimum of at least a £100 lump sum or £25 a month, but this can vary considerably between providers. You won’t pay tax on any profits or dividends you receive.
  • Your money is more at risk than with a cash ISA, but you could get better returns. These types of ISAs are usually most suitable for people who are willing to invest for at least five years, as the value of the investment will go up and down and you could get back less than you put in.
  • Innovative finance ISAs allow you to earn tax-free interest through peer-to-peer lending, where you act as the lender. They can be more lucrative than cash ISAs, but they’re also riskier as there’s a chance the borrower might not pay back the loan. You need to be over 18 to get this type of ISA.
  • Junior ISAs are for children under the age of 18. You can save up to £9,000 in each tax year on behalf of your child. They can’t access their ISA savings until their 18th birthday.

ISAs vs savings accounts

Thanks to the introduction of the personal savings allowance in 2016, basic-rate and higher-rate taxpayers can now earn up to £1,000 interest a year without having to pay tax on the interest. For most people, this means all their savings will be tax-free. So, it has to be said that the tax benefits of cash ISAs aren’t as great as they once were.

However, ISAs can still be a good way to save for additional-rate taxpayers and those with large savings pots. Some cash ISAs may also pay higher interest rates than equivalent savings accounts, so it’s always worth comparing the two.

ISAs give you flexible savings options, as you can invest in cash, stocks and peer-to-peer lending. If you’re a first-time buyer under 40, a Lifetime ISA can be a better option than a savings account as you get a 25% bonus from the government, although there are limits on how much you can pay in.

As with any financial product, the terms can change and it’s important to work out which type of account can benefit your personal circumstances the most.

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