How to choose, and use, different types of ISA
ISAs used to come in just two flavours: cash and stocks & shares. Now we have an array of choices over which of many types of tax-free wrapper to choose.
They all have their pros and cons, and some have quite heavy restrictions on who can use them. Understanding how they work, and the benefits and limitations of each type of ISA will help you to pick the best place for your £20,000 a year allowance.
Here is what is available.
The most popular type of ISA, with more than three times as many accounts subscribed to last tax year than the stocks and shares version1, a cash ISA works very much like an ordinary savings account.
The main difference is that any interest you earn on your savings in an ISA is tax free. Cash ISAs can be instant access, or there can be restrictions on when you can withdraw your money, with money locked away for many years in some cases.
You can transfer your old ISAs between cash products and other types of ISA without the money losing its tax-free status or affecting this year’s allowance, but you have to do this through the providers themselves, rather than withdrawing the cash.
Stocks & Shares ISA
Another term for a stocks & shares ISA is an investment ISA, and in some ways this is the more correct description. Within one of these ISAs you can hold many types of investment, including investment trusts and funds, corporate and government bonds, and individual stocks and shares.
While the value of those investments can go up and down, the advantage of having them in an ISA is that any capital gains you make if an investment rises in value, or any dividends paid to you, are free of tax and do not impact on your tax allowances.
A stocks & shares ISA can also be transferred to a cash ISA in the same way as mentioned above, though not all providers allow ISA funds to be transferred into their accounts.
Lifetime ISA (LISA)
A Lifetime ISA is a more restrictive product than the other ISAs above. It can only be opened by someone over 18 and under 40, and the money you save it in can only be used for buying your first home or taken out to pay for retirement.
To make up for this, the Lifetime ISA is topped up by 25 per cent bonuses from the Government. You can put a maximum of £4000 a year, and the Government will top this up to £5,000. Once you reach the age of 50 you are required to stop contributing. The £4,000 you put in a year counts towards your annual ISA limit of £20,000.
You can withdraw cash from your Lifetime ISA if you are buying your first home, aged over 60 or terminally ill with less than twelve months to live. If you withdraw it at any other time, you will face a withdrawal charge of 25 per cent on your savings, effectively removing the government bonus.
To buy your first home with a Lifetime ISA it must be worth less than £450,000 and you must buy with a mortgage and have had the product open for over a year.
You can transfer your Lifetime ISA to another provider of Lifetime ISAs without paying a withdrawal charge, but unless you are over 60 you cannot transfer it to another type of ISA without paying the 25 per cent penalty mentioned above.
Innovative Finance ISA
Known as an IFISA, this niche form of ISA is not for the risk averse. Instead of standard investments or cash, an IFISA contains peer-to-peer loans – loans made by individuals to either other individuals or businesses.
These high-risk loans can come with high rewards, and in some cases there are forms of ‘security’ for lenders, such as the loans being secured against property or being diversified so that you are not too exposed to any one borrower.
However, IFISAs are ultimately risky and you may not get your money back.
You can open one IFISA a year, or transfer into one from another type of ISA. These products are only suitable for ‘sophisticated’ investors.
Help to Buy ISA
These ISAs are now closed to new applicants, but if you already have one you can continue to pay into it.
A Help to Buy ISA is another product designed to help you to save for a house deposit. You can put in up to £200 a month, and the government will top it up with up to £3000 (at 25 per cent of the total) when you buy your first home.
The home you buy must be worth below £250,000 or £450,000 in London, be the only home you own and be where you intend to live.
You can pay into the ISA until November 2029. You can claim the 25% bonus until November 2030.
Help to Buy ISAs are all savings accounts, so there’s no investment risk.
If you pay into a Help to Buy ISA this counts as your cash ISA for the year so you usually can’t pay into another one, although a few providers offered ‘split ISAs’ which allowed you to bundle this ISA with an ordinary cash one to split it. This is unusual though.
You can transfer your Help to Buy ISA to a Lifetime ISA, but can only transfer £4000 per tax year.
You can also take the money out any time, but you won’t get the bonus unless it is used to buy your home.
Those under 18 can benefit from a Junior ISA, opened for them by parents, where money can grow for them tax free.
Each child can have one Junior ISA, and children who have the old Child Trust Funds (those born between1 September 2002 and 2 January 2011) can transfer these into Junior ISAs too.
The current annual limit for a Junior ISA is £9,000.
Once a child turns 18, a Junior ISA becomes an adult ISA, and they can withdraw the money themselves and do whatever they like with it.
Junior ISAs can be in cash or stocks & shares, and can be transferred between providers.
A flexible ISA is less a type of ISA, and more a feature that is offered by some ISA providers. Flexible ISAs allow you to withdraw money from an ISA and put it back in again in the same tax year without it affecting your ISA allowance.
Not all providers offer this feature, but it can be used with either cash or stocks & shares ISAs.
Whichever ISA you choose to use, it makes sense to use as much of your allowance as possible. With capital gains and dividend tax allowances being cut next tax year, and interest rates rising, it is more likely that those with investments or savings outside of tax-free wrappers will end up paying tax on the growth in their money.
An ISA allowance is ‘use it or lose it’ – it expires at the end of the tax year. Whichever ISA is right for you, the early bird makes the most of the tax relief.
23rd March 2023