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- Disclaimer: This post contains affiliate links. This means that if you purchase anything through a link, I may earn a small commission. This is at no extra cost to you. For transparency, this post contains a referral link to a investment platform. If you sign up we will both receive a free share worth up to £100.
In 1999 the United Kingdom government introduced the individual savings account (ISA). The main advantage of these over a normal bank account is the tax exemption. The money you put into this account is from your after-tax income but when you withdraw money you do not pay any income or capital gains tax. The interest generated is also tax-free. Tax-exempt accounts existed before but the ISA scheme wrapped them all together. Today, there have been six types of ISA: Cash, Lifetime, Stocks & Shares, Innovative Finance, Help-To-Buy and Junior. The first four are available to adults, help-to-buy is no longer available and the Junior account is for under eighteens only. It may be difficult to understand which account is best for you so this blog post will explain all of the different types, helping you to make an informed decision.
Why You Need an ISA
Tax on savings is something that can easily creep up on you over the years, especially if you are a saver, or saving up for something big, like a property. Other earnings also are taken in to account when considering how much tax you pay. All interest from bank or building society accounts, bonds and gilts may be eligible for tax. The amount of tax you pay on your interest and other similar earnings also depends on your income. Fortunately, there is a personal allowance of how much interest you can generate before paying any tax. For the 2020/21 tax year, the following table explains how much interest you can earn before paying any tax.
| Income (£) | Tax Rate (%) | Savings Personal Allowance (£) |
Less than £17,500 |
0 % or 20 % |
£ [5000 – (income-12,500)] *See below for an example* |
£17,501 to £50,000 | 20 % | £1,000 |
| £50,001 to £150,000 | 40% | £500 |
| Over £150,000 | 45 % | £0 |
If you earn less than £17,500, there is a calculation you must do in order to identify how much tax free interest you can earn. If you had an income of £16,000 then we use the formula in the equation above to get: 5000 – (16,000 – 12,500) = 5000 – (3,500) = £1,500. This means that if you had an income of £16,000, you could earn £1,500 of tax free savings interest per tax year.
The second reason is for the investors, who will want to be investing in a tax-free wrapper for when they sell their stocks. In the 2020/21 financial year, there is a £12,300 capital gains tax-free allowance. This means that if the value of your investment increases by over £12,300, and you withdraw it, then you will taxed at a rate of 10 % if you area basic-rate taxpayer, or 20 % if you are a higher or additional-rate taxpayer. Conveniently, the United Kingdom Government have produced a tool which enables you to calculate how much capital gains tax you will pay if you do not wrap it in a tax-exempt account
Eligibility and Conditions
With their being multiple different types of ISA, the eligibility and conditions varies. The main criteria for eligibility is to be 18 or over for a Stocks & Shares, Innovative Finance or Lifetime ISA (LISA) and 16 or over for a cash ISA. You must also be under 40 for the LISA. You must also be a resident in the United Kingdom, a crown servant, or their spouse or civil partner if you do not reside in the United Kingdom. As the name suggests, these accounts are individual and are not held on behalf of others, or joint.
The main condition is the annual deposit limit. Across all the types of account, you can save a maximum of £20,000. On top of this, you can only pay in to one of each type of account in each tax year. For example, if you held a cash ISA with NatWest and HSBC – you must pick one to pay in to for a given tax year. Furthermore, you can only open one of each account each tax year. Transferring from a ISA you paid into in a previous tax year does not apply to this though. You would still be free to invest in any other types of ISA though. Finally, some accounts, such as a the LISA or Junior accounts, have a pay-in limit which is less than the £20,000.
Cash ISA
These are the most common type of account. They allow you to deposit your after-tax money and they generate a steady amount of interest, which you will not pay tax on. These work very similar to normal savings accounts and they may be fixed term or instant access. You can pay up to £20,000 in to one cash ISA in each tax year and when you withdraw any funds, you will not pay income tax on it. You need to be 16 years old to open this account.
Stocks and Shares ISA (S&S ISA)
This type of account is used to buy stocks and funds and has become very accessible with the recent boom of low-fee investment platforms. Although low-fee investing is not new, the popularity has increased with the production of mobile investment apps like Trading 212*. When you sell a stock that has increased in value, you will pay capital gains tax on the value that your stock increased by – the ‘capital gain’. Investing using a Stocks and Shares account makes you exempt from this. This is very powerful for long-term investors. As an extreme example, if you are an investor investing £20,000 every year into stocks. Assuming a rate of return of 6 % per annum over 30 years, your investment will have grown by £ 1,076,033.55 (Isn’t compound interest great?). I did a few ‘back of a napkin’ calculations and this would save you over £200,000 on capital gains tax if you were to withdraw it all. If you plan to invest any of your money, a stocks and shares account is a necessity.
To open this account, you must be 18 or over. There is no reduced maximum pay-in limit for this account either, meaning you could invest up to £20,000 each tax year, assuming you have not paid in to any other type of ISA.
I have an account with Trading 212 which allows me to buy stocks and funds. If you click this link and sign up to Trading 212* you can open a general account or a stocks and shares ISA. If you deposit £1, you will receive a free share worth up to £100. You can sell your free stock and withdraw the profit without depositing any more money. I will also receive a free stock at no extra cost to you.
Lifetime ISA (LISA)
I have a blog post dedicated to the lifetime ISA as I believe it is essential for first-time buyers. When you deposit funds into a LISA, the government will pay in an extra 25 % of what you paid in. For example, if you paid in £1000, the government would deposit £250 for free. This account has two purposes: to help first-time buyers get money for a deposit or for retirement savings. You must be between the ages of 18 and 40 to open this account. If you are using the account to purchase a first property, you must have held the account for at least 12 months. This account does have a limit to the amount of money you can deposit in each tax year, £4,000. You are penalised when withdrawing money from this account, meaning you lose money. Currently, due to Covid-19, this penalty has been removed by the government until April 2021 and you now only lose the government bonus.
Innovative Finance ISA (IFISA)
This is a lesser known account. In the 2018-19 tax year there were only 38,000 accounts subscribed compared to 8,476,000 cash ISA accounts opened. This account allows you to invest in peer to peer (P2P) lending. This is where you loan your money to borrowers. This is similar to how a bank charges interest on a loan that it will give to a business, but you are the bank. It’s generally viewed as a higher risk investment, and your account is not protected by the Financial Services Compensation Scheme. This means that if the company that you hold your IFISA with goes out of business, you may lose all of your money. Most companies offering this type of account are specialist P2P lending companies. Typically, P2P lending offers (but does not guarantee) higher rates of return than a normal savings account. There are also some P2P lending companies with schemes in place that offer you some protection in the event of a borrower defaulting on their debt.
Help-To-Buy ISA (HTB ISA)
You can no longer open a HTB ISA, they were replaced by the LISA. This section is included because before this account ceased to exist, a lot of people signed up to one “just in-case”. If you were one of those people, you may be a bit wondering what to do with that forgotten account that has £1 in it. This account still has its uses though, especially if you want to buy within the next 12 months. With this account, you are given a 25 % bonus on any savings up to £12,000 when you buy a home up to the value of £250,000 (£450,000 for London). In my experience, the interest rate on this forgotten account is a bit higher than other savings account, and many were instant access and came with no withdrawal penalty. If you still intend on using this account, you should be aware that you can only pay in £200 per calendar month. Overall, unless you are buying very soon, or already hold a large amount in the HTB ISA, it may be worth opening a Lifetime ISA.
Junior ISA
This account is more of a subset of the Cash and Stocks and Shares accounts with a reduced savings limit of £9,000 per tax year. It acts in the same way as the cash and stocks and shares accounts, the interest and gains are tax-exempt. The child can hold one of each type of Junior account. A parent or guardian can open and manage the account for the child, but the money belongs to the child. At the age of 16, the child can control the account but no withdrawals can be made until they are 18, when the account will be automatically converted into a normal adult account. Because of the age requirement overlap, a child aged 16 or 17 can open a Junior account as well as a normal adult cash ISA.
Because young children are unlikely to have an income, they are unlikely to be paying any tax on savings and you may be able to find a normal savings account with a higher interest rate. A Stocks and Shares Junior account may be a good way to keep long-term investments safely wrapped up tax-free if the capital gain gets compounded over 18 years. It is also a good way to teach children about tax, investments and savings.
Hopefully this post has demonstrated why you need an ISA and the different options you have to save or grow your money without paying any tax. If you are a long term investor, a stocks and shares account is your best friend.
Andrew
- Disclaimer: This post contains affiliate links. This means that if you purchase anything through a link, I may earn a small commission. This is at no extra cost to you. For transparency, this post contains a referral link to a investment platform. If you sign up we will both receive a free share worth up to £100.