What is an ISA?

At a glance

  • ISA stands for Individual Savings Account
  • They can be more rewarding than other types of savings or investment because of their tax advantages
  • With an ISA, you pay no tax on what your money earns
  • There is a limit to how much money you can put into an ISA in each tax year. This is known as the ‘ISA allowance’
  • There are many different types of ISA, including the Innovative Finance ISA

How an ISA works

The Individual Savings Account - the ISA - was introduced 20 years ago by the government as a way of making saving more worthwhile. It was a simple idea. Most forms of savings and investment create tax liabilities. Paying tax on the interest you earn reduces the returns you can enjoy, and how quickly they can grow. With an ISA, your money can grow faster, because the taxman cannot take a share.

So you can think of an ISA as a tax-free container that protects whatever savings or investment you put inside it from any kind of tax liability. That has an important benefit for you - your cash can grow faster while it is in your ISA, and there is no income or capital gains tax to pay when you come to take it out.

That means putting your savings or investment inside an ISA can be much more effective at growing your money than having the very same saving or investments outside an ISA.

How an ISA works

A basic Cash ISA works much like a conventional savings account, and you can pay in a lump sum - or with some providers make regular monthly savings.

You will be given a passbook, certificate or - more common these days - an online statement to view after you open your ISA, to help you keep track of your money and how it is growing. Once you have used your ISA allowance for the year you simply stop paying in. Your money can keep growing, and you can make another payment into the same account as soon as the next year rolls round.

This means that after a few years of paying in and enjoying interest on your savings you could have a very substantial sum in your ISA account.

The ISA Allowance

So, ISAs are a very good idea for most people. In fact, their advantages – and popularity - are so great that the government sets limits on how much you can put into your ISA or ISAs each year, to avoid the treasury running short of the tax revenue it depends on to fund the country.

This limit is known as your ISA allowance. The limit only applies to current year subscriptions and not the transfer of previous year’s allowances. If you are going to make the most of your ISA, you need to be careful how and where you use your ISA allowance, and what ISAs you will choose.

How ISAs make saving and investing easy

Making savings more attractive by making them tax free and so more rewarding was not a completely new idea. ISAs replaced two older schemes, Personal Equity Plans and Tax-Exempt Special Savings Accounts – PEPs and TESSAs - which both offered tax advantages. But the Stocks and Shares ISAs and Cash ISAs offered back in 1999 attracted savers in a way that their predecessors never did. They were easy to understand, easy to set up and made it easy to see how your money was growing – all advantages that still apply today.

ISAs have evolved over the past two decades, and as a result, have become a basic foundation block for almost anyone who is ready to start building their wealth. Most independent financial advisors will suggest that anyone who pays tax in the UK and who wants to grow their wealth should start with an ISA – and probably more than one.

It’s hardly surprising that there are more than 11 million ISA holders in the UK, according to current estimates.

ISAs are simple – but look before you start

ISAs are simple, and you can sit back and watch your money grow without doing another thing. But you do need to be careful.  Not all ISAs are created equal.  Just as there are many different providers of conventional savings and investment accounts, there are many different ISA providers. Some will offer much better rates than others, which could make them a better choice for you and your ISA allowance. But the choice does not stop there. Just as there are many types of ISA providers, there are many types of ISA.

Back in 1999, there were just Cash ISAs and Stocks and Shares ISAs. Cash ISAs were – and are – simply savings plans. You can get a guaranteed return on your savings, which should be better than an equivalent savings plan which does not have ISA protection. Your initial investment is completely safe, because it is protected by the government’s Financial Services Compensation Scheme (FSCS).

Unfortunately, because interest rates are now so low, Cash ISAs can no longer offer attractive returns. What’s more, thanks to the introduction of the Personal Savings Allowance of £1,000 (£500 for higher rate taxpayers) most people no longer pay tax on their ordinary savings account – which has made the Cash ISA much less popular.

Stocks and Shares ISAs are a little different, in that they are investments, where your money is used to buy something, such as shares on the stock exchange, rather than left as cash (as in the Cash ISA). Like all investments, this means there can be no guarantees, but in exchange for the risk, you can expect a much higher return.

This means your annual ISA allowance can work much harder in a Stocks and Shares ISA than in a Cash ISA. But the ISA story does not stop there. The popularity of tax-free saving and investment has led to the introduction of several other new types of ISA. There is the Junior ISA, allows parents to save on behalf of children under the age of 16. The Help to Buy and Lifetime ISAs (LISA) can provide ways to grow wealth boosted by a substantial bonus from the government – although they are only available to a limited age range and include some important restrictions. There is also the Innovative Finance ISA or IF ISA. The Innovative Finance ISA combines P2P lending with an ISA to make it tax-free. It can offer the potential for excellent returns, and naturally, this is the type of ISA we provide that at RateSetter.

Please note that tax treatment depends on individual circumstances and may be subject to change in the future. Capital at risk. No FSCS protection.

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