How do ISAs work?

How do ISAs work?

What is an ISA?

An Individual Savings Account or ISA is a wrapper that protects your savings (and any interest or investment gains you make) from UK tax.

With a regular savings account, interest is classed as income and you’re taxed on it accordingly. But in an ISA, it’s completely tax-free.

There are various types of ISA to choose from, and you can hold as many as you like. However, you’re only allowed to pay into one of each type each tax year*.  In total, your contributions can’t exceed the ISA allowance (£20,000 for 2023/2024).

Always keep in mind that tax rules can change in future.

*This is set to change on 6th April 2024, when you will be able to open multiple ISAs of the same type in the same tax year. Your contributions will not be able to exceed the ISA allowance of £20,000.

The different types of ISA

There are four types of ISA available for adults:

  • Cash ISAs
  • Stocks and shares ISAs
  • Lifetime ISAs
  • Innovative Finance ISAs

Parents can also open a Junior ISA for their children, but this doesn’t count towards your personal ISA allowance. It’s held in the child’s name. Find out more about Junior ISAs in our helpful guide.

Below we’ll look at some of the pros and cons of each type of ISA, but remember, what’s right for you and your family will depend on your own circumstances. For tailored financial advice, you can book an appointment with a Specialist Financial Adviser from Wesleyan Financial Services.

Cash ISA

Perhaps the most simple type of ISA is the cash ISA. It allows you to earn tax-free interest on your cash savings. You can usually choose between a variable or fixed interest rate.

A variable rate cash ISA will usually have a lower rate of interest, but will allow you to withdraw money whenever you need to. A fixed rate cash ISA may provide you with a slightly higher rate, but you might need to leave your money in for a set period of time.

Pros and cons of a Cash ISA…
A low-risk way to save
Some cash ISAs allow instant access to funds
Low interest rates mean little potential for growth

Stocks and shares ISA

In a stocks and shares ISA, your contributions are invested in the stock market rather than held in cash.

Some ISAs will allow you to choose the investments yourself. Others (like our Wesleyan Stocks and Shares ISA and Wesleyan Unit Trust Managers Unit Trust ISA) are invested in funds which are managed on your behalf.

By investing your money, you may be able to grow your pot faster than in a cash ISA – and there’s no tax to pay on any returns from your investments. Like all investments though, there’s an element of risk involved. You could get back less than what you put in.

Bear in mind too that most investment ISAs recommend leaving your funds in place for a minimum of five years. That’s to allow more time for any potential growth.

Pros and cons of a stocks and shares ISA…
Provides greater potential for growth than a cash ISA
No capital gains tax to pay on any investment returns
Investments can go down in value as well as up, and you may get back less than what you put in
Initial and ongoing charges usually apply

Lifetime ISAs

Lifetime ISAs are designed to help young adults save either for their first home or for retirement. They are only available to those between 18 and 39 years old.

You can save up to £4,000 a year in a Lifetime ISA (out of your full £20,000 allowance). The government will add 25% to your contribution, meaning a maximum ‘bonus’ of £1,000 a year.

Remember though, you can only use these savings for one of two things – and both come with conditions. If you’re buying a house with the proceeds, it’ll have to be below the value of £450,000, which can be tricky in some parts of the UK. If you’re saving for retirement, you won’t be able to touch the money until you’re 60.

If you take the money out early, or for any other reason, you’ll be charged 25% of the amount you withdraw. If you’re taking it all out, bonus and all, you’ll actually get back less than the money you paid in.

Pros and cons of a Lifetime ISA…
Government contribution of up to £1,000 per year until your 50th birthday
Contributions limited to £4,000 per year
25% charge for withdrawing early. Full withdrawal outside the contract terms would mean you get back less than you put in.

Innovative Finance ISAs

An innovative finance ISA (IFISA) allows you to invest your tax-free ISA allowance in peer to peer (P2P) lending. That means your money is effectively borrowed by individuals or businesses through a lending platform.

As with most loans, there’s interest for the borrower to pay – and that interest represents your return on investment.

IFISAs can be appealing due to the opportunities to earn high rates of interest, but as with any lending, there’s always the risk of the borrower defaulting on the loan. Not all IFISA investments are protected by the Financial Services Compensation Scheme.

Pros and cons of an IFISA…
Higher interest rates than some other ISA types
Investment could be at risk if borrower defaults

What is the ISA allowance?

The ISA allowance for the 2023/24 tax year is £20,000. That’s how much you can add to your ISA (or combination of ISAs) over the course of the tax year.

The tax year runs from 6th April to the following 5th April. Be aware, if you don’t use your full allowance during the tax year, you won’t be able to carry any over.

You can hold numerous ISAs at any one time, but only pay into one of each type in the same tax year. For instance, you can pay into a With Profits Stocks and Shares ISA, a cash ISA and a Lifetime ISA in 2023/2024, but you couldn’t contribute to two different cash ISAs. This is set to change on 6th April 2024, when you will be able to open multiple ISAs of the same type in the same tax year (excluding Lifetime ISAs).

Some people like to spread their allowance in this way, enabling them to pursue the potential rewards of an investment ISA while holding other savings in cash.

Transferring an ISA

You can transfer your ISA savings to a new provider (and indeed a different type of ISA) at any time.

If it’s money you have saved in previous tax years, then it won’t impact your allowance – and you can transfer as much or as little as you want. For instance, you could transfer £15,000 of ‘old’ cash ISA savings into a new stocks and shares ISA and still add a further £20,000 that tax year.

Any current-year contributions and any associated growth must be transferred in full though. You’ll have a remaining allowance once the transfer is complete.There are a couple of things to bear in mind when transferring your ISA. Firstly, you should never do it manually by withdrawing the money yourself. Always contact your new provider and allow them to arrange the transfer for you.

Secondly, you might need to pay another initial set-up fee or advice charge when you move to a new provider.

The rules for transferring ISAs are set to change on 6th April 2024, when partial transfers of current-year contributions will be allowed.

If you have a Lifetime ISA, you should also note that transfers to a different type of ISA (before you’re 60) effectively count as a withdrawal – meaning you’d be subject to a charge.

Paying into an ISA

Most ISAs will allow you to set up regular monthly contributions, as well as make ad-hoc lump-sum payments. This allows you to maximise your allowance by ‘topping up’ your account when you find yourself with cash to spare.

You can open a Wesleyan Stocks and Shares ISA or WUTM Unit Trust ISA with an initial lump sum investment of £1,000, or by setting up monthly contributions.

What happens when you take money out of an ISA?

The good news is that when you withdraw your money from an ISA, there’ll be no income tax or capital gains tax to pay.

However, depending on the terms of your account, there could be a penalty for early withdrawal – so pay close attention to the small print.

If you’re investing in a stocks and shares ISA, you should be prepared to leave your investment in place for a minimum of five years.

Bear in mind the value of investments and any income can go down as well as up, and you may get back less than you invest.

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