What is an ISA?
An Individual Savings Account (ISA) is an account that allows you to save or invest entirely tax-free. There are currently four different types of ISAs available:
- Cash ISA
- Stocks & Shares ISA
- Innovative Finance ISA
- Lifetime ISA
You are able to stash up to £20,000 per year in ISA accounts, which is a lot of money to be putting away. You can put the whole amount into one type of ISA account or split your money between different types of ISA accounts. How do you know which ISA account to use? Should you use more than one? What are the differences? Which type of ISA account is best for your circumstances? In order to answer these questions here’s a brief summary of the different types of ISAs available and what you need to consider before deciding which the best option for you is.
A Cash ISA is like a standard savings account, the only difference is that you will not pay tax on any interest. On a standard savings account you will pay tax on interest earned over £1,000 for a basic rate tax payer (£500 for a higher rate tax payer and £0 for an additional rate tax payer). The average interest rate on UK savings accounts in 2016 was 1.23% so as a basic rate tax payer you would need to have savings of £81,300 to earn £1,000 in interest (£40,650 as a higher rate tax payer).
If you do not earn sufficient interest on your savings to pay tax then there is little difference in whether you have a Cash ISA account or a standard savings account. You can obtain a better interest rate from current accounts, see bankaccountsavings.co.uk, here you can enter the amount of savings and it tells you which banks to open current accounts or regular savings accounts with in order to maximise interest. For example, you can get 5% interest with Nationwide’s current account, this is considerably more than any Cash ISA so make sure you shop around for the best rate.
Holding savings as cash is recommended if you are saving for the short term (up to five years) or saving an emergency fund that you may need access to immediately. If you hold money as cash in the long term, in real terms the value of your cash is reducing. This is due to inflation, currently inflation is at 3% and the average interest on savings account is below this therefore the spending power of our savings is reducing. If you intend to save for the long term (over 5 years) you will most likely be better off investing.
A Cash ISA can be opened with banks and building societies as well as some National Savings and Investments products.
Stocks and Shares ISA
A Stocks and Shares ISA is where you invest in things such as:
- Corporate and government bonds: a bond is where you lend money to a company or a government and in return receive interest.
- Shares: buying a share in an individual company means you own part of that company. As the price of the company goes up so does your investment. A lot of companies also share their profits with investors in the form of dividends, the more shares you hold in a company the higher the dividends you will receive.
- Funds: a fund is a mixture of various company shares, bonds and cash.
Over the past three decades the FTSE All-Share has returned on average approximately 6% per year. If you include dividends the returns would be approximately 10%. These returns are much higher than what any cash ISA has to offer so you can see the appeal. Please note investments can also go down quite dramatically as investors found out in 2008 when the FTSE dropped an astonishing 31%. This is why it is recommended to only invest in the stock market for the long term, at least five years, so you have enough time to ride out the downturns.
Any growth or dividend income you receive is entirely tax free. If you are investing for retirement, is it better than investing in a private pension through your employer? Most employers match the amount you pay into your pension up to a certain limit so you are doubling your pension fund straightaway and your pension is deducted prior to paying tax. For this reason I recommend contributing the maximum that your employer matches into your pension, prior to considering any other investment for retirement. This is a basic rule of thumb, there are many other things to consider such as whether you are a basic or higher rate tax payer which I will cover in another post.
If you are considering investing in the stock market, I would highly recommend a book by Tim Hale called ‘Smarter Investing’. This is a book I refer back to time and again (a full review will follow later this month), it shows you how to build and hold a sensible portfolio to give you the greatest chance of reaching your goals.
Innovative Finance ISA
With an Innovative Finance ISA (IFISA) you can invest in the following:
- Peer-to-peer lending (P2P lending): this is where you lend money directly to individuals or businesses and cut out the middle man (banks).
- Crowdfunding: this investment is usually in the form of debentures (fixed loan that is secured against the company’s assets, similar to a bond).
With P2P lending you can either opt for easy access (e.g. Ratesetter offers 3.2%) or fix your savings usually up to five years (e.g. Ratesetter offers 4%). These interest rates are better than on a Cash ISA so it is worth considering if you intend to put money away for the short term (i.e. up to five years). However the risk is that the business or individual you have lent your money to is unable to repay the loan, therefore you could lose your money.
With crowdfunding you can expect rates of 4-7% but as you are investing in companies that are in their very early stages the risk is higher than other investments such as stocks and shares. If the company is not successful and unable to repay the loan you will lose your money. The money is usually lent for a fixed term of up to five years.
All IFISA platforms have their own way of reducing this risk such as spreading your money across multiple businesses or setting aside capital as a reserve, make sure you understand how the platform you are using mitigates risk. Note: P2P platforms are not protected by the Financial Services Compensation Scheme like a Cash ISAs are.
A Lifetime ISA (LISA) is designed to allow to your save money in order to purchase a property (only if you’re a First Time Buyer) or for retirement. You can only open this type of ISA between the ages of 18-40. The total amount you can save in a LISA is £4,000 per year. A government bonus of 25% is added to your LISA account each year, so if you save the maximum amount of £4,000 you will receive a bonus of £1,000 per year up until the age of 50. With a LISA you can choose to save as cash or invest.
Unless you are withdrawing the money to purchase a property you are required to keep your money in the LISA until the age of 50 (except for extreme circumstances).
If you intend to purchase a property I would suggest opening a LISA as soon as possible, the 25% bonus is a fantastic deal. You should consider how many years you intend to save for before purchasing a property before deciding whether to keep the money as cash or invest in shares. If you are saving for the short term (under five years) I suggest cash, if you are saving for the long term (over five years) I suggest invest.
If you are opening a LISA solely for retirement purposes it is wise to consider other pension schemes as you may be better off investing with your employer private pension if you are a higher rate tax payer.