Maximising Returns with Tax-Free Individual Savings Accounts

September 21, 2023

An Individual Savings Account, also called an ISA, is a type of retail investment scheme available to UK residents. It enables people to build their savings and investments without worrying about taxes. Payments to the account are made from after-tax income, and the interest on the account is then exempt from income and capital gains tax.

There are several types of Individual Savings Accounts, including cash ISAs, lifetime ISAs, stocks and shares ISAs, junior ISAs, and even innovative finance ISAs. It’s worth knowing how they work so that you can choose the right one. In this article, you’ll find the definition, an explanation of how each type works, the terms and conditions for getting such an account, and some tips on how to manage one. 

What Is an ISA?

An Individual Savings Account offers the opportunity to save and invest without paying tax on the interest or income you receive. The government sets an annual limit on the maximum amount that can be placed into an ISA. This limit is not fixed and increases each year to account for inflation. For example, in 2023/2024, the maximum you can save in ISAs is £20,000.

There are several options to choose from with varying degrees of flexibility. Below, we’ll break down each of these in more detail. It is possible to allocate funds to one type of ISA or spread the annual limit across many ISAs during each tax year.

Does an ISA Offer Benefits?

The main advantage of an ISA is that investment income is tax-free. Individuals also don’t have to pay taxes when they withdraw the money. While this savings option sounds tempting, one question remains as to how favourable it is, given that since the introduction of the Personal Savings Allowance (PSA), people rarely pay tax on any savings accounts.

Thanks to the Personal Savings Allowance, people can get up to £1,000 of interest without paying taxes, depending on their Income Tax band:

Basic rate — £1,000

Higher rate — £500

Additional rate — £0

Individuals are also eligible to use their Personal Allowance to earn interest tax-free, but only if they did not use it up on wages or pensions. With these benefits in place, people on the basic rate often have virtually no tax to pay. However, ISAs can still be a favourable option, and not just for high earners. So, let’s consider the pros. 

Firstly, an ISA can help  protect your savings from tax over time. This is important because interest rates can rise in the future. So, if you’re saving for the long term, over time, you could be putting away more money than you expect or realise.

Secondly, you may find it advantageous to shield your investments from capital gains tax. This becomes more relevant if you plan to use an ISA as an investment, as ROI could be unpredictable. 

Finally, with an ISA, you can take advantage of government allowances if you are saving for a first home or retirement. This way, you can make the most of government top-ups.

Different Types of ISAs and Their Features

For adults, there are four main types of ISAs; each of them works slightly differently and offers varying degrees of flexibility and potential returns. That’s why you need to consider your savings goals when choosing which one to go for. For those under the age of 18, there are also junior ISAs available. These work similarly to adult ISAs but with some key differences that we’ll discuss below.

A Cash ISA

A cash ISA is similar to a standard savings account, except you are not required to pay taxes. There are different types of cash ISAs, such as easy access ISAs, fixed-term ISAs, and notice ISAs, each with its own features and benefits. 

  • Easy access ISAs allow you to withdraw money at any convenient time without penalty. They typically offer lower interest rates than fixed-term ISAs but are more flexible. 
  • With fixed-term ISAs, you need to keep money in for a set period, usually between one and seven years. They often provide higher interest rates than easy-access ISAs.
  • Notice ISAs require you to give notice before you can withdraw your money. The notice period can range from 30 days to several months, depending on the type of account. Their rates may be higher than easy-access ISAs but lower than fixed-term ISAs.

It’s advisable to compare cash ISA rates and choose the best account for your needs. Importantly, cash ISAs offer competitive interest rates, often higher than those on conventional savings accounts. If you choose an account with the highest interest rates possible, you can maximise your benefits, and you’ll still have access to your money when you need it.

Most cash ISAs are easy to manage, and you can transfer your account to another provider if you find a better deal elsewhere. A cash ISA is characterised by simplicity and generally easy withdrawals. What’s more, your money is covered by the FSCS up to £85,000.

Stocks and Shares ISAs

Stocks and shares ISAs allow you to hold investment products such as corporate bonds, funds, shares, and stocks. You won’t have to pay UK income tax or capital gains tax on money made from investments. To get a stocks and shares ISA, you may contact a bank or an investment platform. They charge fees for their services, for example, trading and annual fees, so you should look at all available options to ensure you don’t pay too much.

There are two main types of stocks and shares ISAs:

  • Ready-made stocks and shares ISAs that are managed by a professional fund manager who invests your money on your behalf. 
  • Self-invested stocks and shares ISAs that allow you to choose assets you want to invest in and manage your own portfolio.

There may well be a higher return on this type of ISA than a cash ISA, but there is also more risk as investments can fall as well as rise. It is even possible that you get back less than you put in. In addition, the process of withdrawing the cash can be longer, so you may not be able to access your money instantly.

As with cash ISAs, if the company you invested in goes bust, your funds will be protected by the FSCS scheme up to £85,000. However, remember that you are not immune to deterioration in the performance of your investments and any downturn.

A Lifetime ISA (LISA)

A Lifetime Individual Savings Account (LISA) can be used to buy your first home or save for retirement. You need to be over 18 but under 40 to open a lifetime ISA. You can invest up to £4,000 each year until the age of 50. It is compulsory to make a first contribution to an ISA before the age of 40. In addition, the UK Government will add a 25 per cent bonus to your savings up to a maximum of £1,000 per year.

The lifetime ISA limit of £4,000 counts towards the annual ISA limit. You can keep cash or shares in a lifetime ISA or a combination of both. When you turn 50, you won’t be able to make payments into a LISA. The account will remain open, and your savings will still earn interest or investment income.

You can withdraw money from a lifetime ISA to buy your first home when you turn 60 or if you are terminally ill and have less than 12 months to live. If you withdraw money or assets for any other reason (unauthorised withdrawal), you’ll pay a 25 per cent fee.

An Innovative Finance ISA (IFISA)

An Innovative Finance ISA (IFISA) is a type of ISA that allows you to use your tax-free ISA amount to invest in peer-to-peer (P2P) loans rather than cash or shares. P2P lending brings together investors and borrowers, and you receive interest on the loans you make. Whatever interest you make is not taxed. The annual investment limit in an IFISA is the same as for other ISAs and is currently £20,000. 

Innovative Finance ISAs offer higher potential returns than cash ISAs and savings accounts and the possibility of your money growing faster, but they also come with higher risks. Another drawback is that you cannot get instant access to your money. It’s important to consider your risk profile and determine your long-term goals before investing in an IFISA.

A Junior ISA

A child (under 18) living in the UK can get a junior ISA. This can be the replacement for Child Trust Funds. As with regular ISAs, the money can be invested in cash or shares, but unlike in the adult version, it cannot be accessed instantly. In 2023/2024, the savings limit for Junior ISAs is £9,000.

Parents or guardians with parental responsibility can open a Junior ISA and manage the account, but the money belongs to the child. The child can take control of the account when they turn 16 but cannot withdraw the money until they turn 18. All 16-17-year-olds who have something to save can open both an adult and a youth account and enjoy the benefits of both, but only until they turn 18.

There are also additional requirements for children living outside the UK: they can get a Junior ISA only if their parent or guardian is a Crown servant and they depend on them for care.

If you’re interested not only in savings but also in business accounts, check out Payrow’s website. The advanced and secure platform offers multi-currency payment accounts in the UK, allowing access to cross-border payments and automated invoicing. 

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