ISAs explained

Although they offer generous tax-incentives, millions of savers fail to use ISAs to their advantage each year, instead preferring to stick to standard savings accounts instead. To help you to make the most of your savings we’ve put together a guide to ISAs that explains what they are, how they work and why it makes good sense to invest in them.

What is an ISA?

In simple terms, an ISA (or Individual Savings Account) allows you to save money without paying tax on the interest you receive. There are two types of ISAs available:

Cash ISA – acts as a savings account into which you deposit cash.
Stocks and shares ISA - acts as a tax-free wrapper for your investments.

You can pay into one account of each type during the tax year, which runs from 6^th April to 5^th April the following year.

We’ll talk about each type of ISA in more detail later on in this guide. You can jump straight to these sections using the links below:

Jump to: Cash ISAs explained
Jump to: Stocks and shared ISAs explained

Why invest in an ISA?

ISAs have a number of tax benefits that make them a desirable investment tool:

There’s no tax payable on the income you receive from your ISA investment.
There’s no tax payable on any capital gains that may arise.
And there’s no need to declare any ISA income or capital gains on your tax return.

Who can open an ISA?

To open an ISA you must be:

A UK resident (or a Crown employee serving overseas, or the spouse of such an employee).
Aged 16 or over to open a cash ISA.
Aged 18 or over to open a stocks and shares ISA.

Remember! To open an ISA you’ll be required to provide a form of ID, such as a passport or driving licence, along with your National Insurance number.

What is an ISA allowance and how does it work?

The ISA allowance is the amount the Government permits you to invest in your ISA accounts during each tax year with the purpose of earning tax-free interest.

At the start of each new tax year (6th April) you’ll receive a new ISA allowance, and it’s wise to use as much of your allowance as you can as it cannot be rolled over to the next tax year. Once you’ve invested money in your ISA you can keep it there, and it will continue to earn tax-free interest. By using your allowance to top up your ISA each year it’s possible to accumulate a significant amount of tax-efficient savings.

Remember! By investing as much as you can into your ISA at the start of the tax year you can earn the maximum amount of interest on it.

What is the current ISA allowance?

The ISA allowance for the current tax year (2012/2013) permits:

Investment of up to £5,640 in a cash ISA; and
An overall combined investment in both a cash ISA and a stocks and shares ISA of up to £11,280.

What investment options do I have?

Your allowance is flexible in so much as it provides you with the following investment options:

You can invest up to the maximum allowance permitted for a cash ISA with the option to invest the remainder in a stocks and shares ISA (up to a combined overall investment limit of £11,280 in tax year 2012/2013); or
You can invest up to the full allowance in a stocks and shares ISA (£11,280 in tax year 2012/2013).

Can I withdraw money from an ISA?

With an easy access cash ISA you can withdraw money without giving notice and without penalty; other types of cash ISA (e.g. fixed rate ISAs) may be more restrictive. However, when you withdraw money from a cash ISA or stocks and shares ISA you cannot re-invest it at a later date with the intention of topping the balance up. This is because you can only invest up to the ISA allowance for that tax year, regardless of how many withdrawals you make.

For example: During tax year 2012/2013, if you have a cash ISA allowance of £5,640 and you invest £4,500 at the start of the tax year you can still invest a further £1,140 before the year ends. However, if you withdraw £1,500 of the original £4,500 you will still only be able to invest an additional £1,140 as your maximum investment limit for the year is £5,640. Similarly, if you invested the full £5,640 at the start of the year and then withdrew half of it (£2,820), you would not be able to pay in any more money until your new allowance became available at the start of the next tax year.

Can I switch ISAs?

The current rules allow you to transfer a cash ISA to a stocks & shares ISAs but a stocks and shares ISA cannot be transferred to a cash ISA; you can also transfer each type of ISA to another product of the same type (e.g. you can transfer one cash ISA to another).

Remember! When a child trust fund matures it can transferred into an ISA.

In the next part of our guide we look at cash ISAs in more detail.

« Other things to consider when opening a savings account

Cash ISAs explained »