What are ISAs and how do you choose the best one for you?

With inflation forecast to hit up to 8% next month, investing and saving tax efficiently is one of the best ways to help your money keep up with rising costs.

Everyone is eligible to put £20,000 into an Individual Savings Account (Isa) every year, which allows your money to grow tax-free, whether you save or invest it.

But with the highest paying instant-access cash Isa only paying 0.7%, and inflation predicted to hit more than ten times that in April, investors are looking at stocks and shares Isas this year, just to give their money a chance of keeping its value over time.

‘Any kind of Isa involves a balance of risk and reward, and at times of higher inflation we are reminded that this goes for cash Isas, too,’ says Sarah Coles, personal finance expert at wealth platform Hargreaves Lansdown.

‘In return for not risking losing the money you put in, you accept lower potential rewards, and part of this trade-off is that you face the risk that you will lose the spending power of your money after inflation.’

However, as Sarah points out, using a stocks and shares Isa means enduring volatility.

‘You accept your investments will rise and fall in the short term, in return for the fact they have the potential to grow more over the long term. It means less risk that you’ll lose money after inflation over five to ten years or more,’ she explains.

Since 1999, when they were introduced, Isas have been a way for all savers and investors to put money away without paying tax on its growth.

Ordinarily, if you earn interest on your savings or your investments grow in value or pay dividends, you pay tax on the extra that you own. Once your money is placed inside an Isa wrapper, it is protected from paying this tax.

This protection continues if you move your Isa from one provider to another, or if you change your account from one invested in stocks and shares to one where your savings are in cash. The only time that you lose this protection for your money is when you take it out of its isa wrapper without following the correct processes.

Who needs an Isa?

Anyone who is otherwise going to pay tax on their savings and investments should consider an Isa.

If you are going to invest in stocks and shares, there are only two ways to ensure that they grow without accruing a tax burden.

The first is if they are in an Isa, and the second is if they are in a pension. A pension has other tax benefits, but you can only access the money after the age of 55, and this is due to rise.

Similarly, if you are paid interest on your cash savings, this will be taxable if it is outside an Isa.

However, it is worth noting that, because we can all earn some interest and receive some dividend payments tax-free every year, Isas are most beneficial to those who have large pots of savings or investments.

Basic rate taxpayers can earn £1,000 in interest each year without paying tax on it, while higher rate taxpayers can earn £500. You only have to pay capital gains tax (payable on shares that rise in value) on any gains of more than £12,500 a year.

Everyone can earn £2,000 a year from share dividends outside an Isa without being penalised, too.

If you think you are never going to surpass these levels then you may not need to put your money in an Isa, but it is worth remembering that tax allowances can be withdrawn or reduced at any time, while you will hopefully build up a bigger nest egg over time, meaning you could surpass these figures.

Cash Isas

If you put your money in a cash Isa, you can’t lose your money – the money you invest, plus interest, is what stays in the account.

That said, you may well find that your money goes down in value in real terms, especially as right now when inflation is way above even the best interest rates on offer. You will still get the tax advantages mentioned previously, but you could get a higher rate on cash savings outside an Isa at present.

A cash Isa works just like a savings account, and you can choose one that lasts for a number of years with a fixed interest rate and penalties for early withdrawal, or one where you can withdraw the money at any time.

Rachel Springall, financial expert at data service Moneyfacts, says that the best deal on a cash Isa is currently 0.7% with Marcus Bank, which is owned by Goldman Sachs.

However, Rachel says that non-Isa savings accounts beat cash Isas on rates, citing Virgin Money, which pays 1% interest on easy access savings.

‘Whether savers continue to use cash Isas is debatable as it really depends on what they have to invest and how long they plan to let it grow,’ she says.

‘Depending on how much they have to invest outside of an Isa, savers may well stay within their Personal Savings Allowance and not pay tax on their earned interest.’

An Isa to suit your needs: other options

The world of ISAs is quite complex, and there are a couple of other options you have to save tax-free.

Lifetime Isa

The Lifetime Isa (Lisa) allows you to save either for your first home or
for retirement.

These can only be opened by someone over 18 but under 40, and you can put money into it until you reach 50.

The big draw of the Lisa is that the government adds a 25% bonus to the pot. You can put in a maximum of £4,000 a year to this account, to which the Government will add a maximum of £1,000.

Since you can only get this money out to buy your first house (which must be worth less than £450,000) or once you are over the age of 60, without punitive fees, you need to be very sure this is the right product for you before opening one.

Innovative finance Isa

There is also a product known as an Innovative Finance Isa, which you can use to lend through peer-to-peer sites, or invest in crowdfunding projects.

By their very nature, these Isas are quite risky, however, so it is really important you do your research before opening one, and understand that your money may go up as well as down.

Junior Isa

If you have a child under 18, they can have a Junior Isa, which has a £9,000 annual limit.

These products work in a similar way to adult ISAs, in that you can save in cash or invest in shares tax-free for your child, but once the child reaches 18 they will have control over the money, and it will roll over into an adult Isa.

The money needs to stay in the Isa until this point.

Stocks and shares Isa

For those considering putting aside money for five years or more, a stocks and shares Isa can make more sense.

This allows you to invest in a wide range of different shares and/or funds, and in many cases you can buy and sell them yourself.

Any gains you get or dividends that you are paid are given to you tax-free, and over time you can accrue a large investment portfolio if you use as much of your Isa allowance as you can.

Historically, over most long periods of time, stocks and shares have performed better than cash savings, and by investing you have more of a chance to outrun inflation than if you put your money into a cash Isa.

‘While there is no guarantee that stock markets will rise in the coming years, historical evidence is fairly clear that markets tend to rise quite strongly over the long term,’ says Adrian Lowery, personal finance expert at Tinley Investment Management.

Adrian gives the example of the MSCI World equities index, which tracks the performance of medium and large global stocks. This index is 59% where it was five years ago, he says.

‘That means even after taking fees into account, £1,000 invested in a simple global equities tracker ten years ago would now be worth more than £3,000.’

However, Adrian acknowledges that the risk of losing money with investment can be ‘intimidating,’ particularly at a ‘time when conflict and potential economic shocks are causing market volatility’.

Whether a stocks and shares Isa is right for you or not will depend on your goals, the time you are planning to put the money away for and your risk appetite. Some people are more comfortable with seeing money move up and down than others.

Sarah Coles, from Hargreaves Lansdown, says it makes sense to start with funds – which invest money into lots of different companies – if you are a novice investor.

‘They will help spread your risk from the first pound of investment,’ she says. ‘If you’re new to investing, it can seem like a weird and unfamiliar world, where everyone else seems to be fluent in a language you don’t speak.

‘The good news is that you don’t have to be a master investor to make a start. You just need to get your head around the basics, and start small.’

If you don’t want to invest all of your money in a stocks and shares Isa at once, Sarah suggests starting with a direct debit into one and putting as little as £25 a month in.

‘Once you’ve made a start, commit to learning more about it.
Just a few minutes a week here and there can help you build your knowledge, so as your investment starts to grow, you’re ready to consider new funds to add to your portfolio.

Switching

If you have Isas from previous years, the good news is you can move them to other providers, without affecting this year’s allowance or your tax-free status.

If you have cash Isas and decide to change them into stocks and shares Isas or vice versa, this is possible too.

To do this, you need to find a provider that accepts ‘transfers in’ from other Isas. Fill in a form with the new provider and they will handle the transfer.

However, do not withdraw the money yourself in order to put it into the new Isa, as it will lose its tax-free status.

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