The beginner’s guide to ISAs and savings accounts

By Philippa Guy

Heard of an ISA but not sure what it stands for or how it could help you save?

This article is an introductory guide to the world of ISAs, examining the various types on offer and how they differ from other savings accounts. If you’re not sure which savings account is right for you, this article will help to demystify the various options so you can have a clearer idea of what’s involved when choosing an ISA.

What is an ISA?

The term ISA stands for an Individual Savings Account. ISAs were created by the government in 1999 as a tax incentive to encourage people to save more regularly. Cash ISAs work by offering you the chance to save without having to pay tax on the interest that your savings earn. Or if you choose an investment ISA, you won’t be charged any tax on the profit or returns that your investment makes. In other words, ISAs are accounts that offer you protection from paying tax on your savings or investments, known technically as tax wrapper accounts.

How are ISAs different from saving accounts?

One of most common types of bank accounts is the saving account. Unlike current accounts, saving accounts are designed to help you save money over a long period of time. There are different types of saving accounts, but usually you will be paid interest monthly or yearly on the money that you save, slowly increasing your overall amount (known as your capital). Although this is clearly an incentive to save money, this interest may be taxed. This can feel frustrating, and, in contrast, ISAs allow savers to keep all of the interest earned on their ISA accounts.

How do ISAs work?

This depends on the type of ISA! Every tax year, you can save up to a certain amount of money in an ISA. The tax year runs from 6 April to 5 April and you can find the year’s annual allowance online or from a bank. You can choose to invest up to this amount in a cash ISA, an investment ISA (also known as a stocks and shares ISA) or an innovative finance ISA; or you can use a combination of all three types of ISA. You can invest up to the annual allowance every tax year by opening a new ISA.

Even within each type of ISA, there is a huge range of options and providers. You can open a cash ISA with all the major banks and building societies (though you might need to hold a current account before opening an ISA with some banks). You can choose how to access your ISA – online, in a branch or by telephone. Even supermarkets and The Post Office offer ISAs so it’s worthwhile doing some research to find the best option for you. You must be a resident in the UK and aged at least 16 for a cash ISA and 18 or over for a stocks and shares or innovative finance ISA.

Cash ISAs

The first type of ISA is a cash ISA. This account offers you the option to save money without paying any tax on the interest that your savings earn. There is no charge to open one and all major bank or building societies offer cash ISAs. The minimum deposit can be £1 and there are no management or administrative costs.

Some cash ISAs, known as instant or easy access ISAs, will give you instant access to your money, allowing you to withdraw your savings at any point. However, their interest rates are usually lower and variable, so they may decrease. Other cash ISAs offer fixed interest rates, so they will pay a guaranteed amount of interest for a set time (so you’ll know exactly what you’ll make on your savings). These are known as fixed rate cash ISAs. Their interest rates are fixed and generally higher but beware… these ISAs lock your money away for a certain period (generally between one and five years). The advantage of this ISA is that you can earn more interest but you will pay a large penalty if you suddenly need to withdraw your money before the end of its term. Therefore, this ISA initially might seem a good option for locking up your savings as a form of self-control, but you will lose out if you suddenly need to withdraw emergency cash! So it’s really important to consider whether you might need to access your savings immediately in a crisis or if you can afford to lock away some money for a year or more

In conclusion, if you are in the fortunate position of having large sum of money that you are happy to leave untouched in a bank, a fixed rate cash ISA could be a good option. However, if you want instant access to your money or if you only want to invest a small amount each month, an easy assess cash ISA would be a much better choice.

First-time home buyers also have the option to choose a Help to Buy ISA, which is also a cash ISA. However, unlike other ISAs, you can only open one Help to Buy ISA and you can only pay a certain amount into this ISA every month. It promises to offer a bonus from the government to help you buy a new house, but it’s really important to read the terms and conditions of this ISA – many people didn’t realised that this bonus cannot be used for the initial deposit on their new home, leading to much confusion and heartache!

What are investment ISAs?

Also known as stocks and shares ISAs, these ISAs are linked to the stock market. You are not saving your money but investing it. An important fact to note: these ISAs are a lot more risky and are not recommended for short-term saving!

Instead of receiving tax-free interest like a cash ISA, you will receive regular tax-free dividends (a portion of a company’s earnings you have invested in). Essentially, as with all investments in stocks and shares, there is no guarantee that the amount you invest will go up. Although stocks and shares can increase in value, your investments could decrease or you could even lose all your money.  To make it worthwhile, you need invest for at least 5 years in this ISA and there will be charges for setting up and managing this ISA. You can withdraw your investments at any point if you need to access cash suddenly, but again you could get back less than you initially invested due to these management fees or penalties. In conclusion, investment ISAs are a long-term investment option for those who can afford to take risks with their money. Seeking independent financial advice is highly recommended before choosing this ISA!

Innovative finance ISAs

The latest ISA to be introduced is called an innovative finance ISA and it is only recommended for sophisticated investors who are aware of the high levels of risk involved when investing on a peer-to-peer basis.

Top Takeaway

When deciding about the type of savings to choose, you need to consider both your present earnings and your strategy for the future. Unfortunately for savers, saving accounts are paying very low interest at the moment so paying off your credit card or any other debt would probably be more sensible than saving money. Furthermore, if you earn less than £17,000 a year on income and savings, you do not have to pay any tax on your interest from your savings. But you may want to build up ISAs for the future when you start earning more. Therefore having a long-term strategy for saving is really important, as well as taking good advice from a variety of sources.

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