Understanding ISA investment basics

An ISA, or individual savings account, is a tax-efficient wrapper for savings and investments. Quite simply, if you have cash savings or are investing, there is no reason not to use an ISA wrapper.

Each tax year, we are each given an annual ISA allowance. It is a ‘use it or lose it’ allowance, meaning that if you don’t use all or part of it in one tax year, you cannot carry it over to the next.

Many people leave their ISA investing to the last minute, but this simple introduction and our how to choose a managed fund guide should help you stay motivated throughout the year.

See our views and research all Elite Rated funds

What are the main benefits?

There are various tax advantages to saving or investing through an ISA. Some of the main benefits include:

  • No capital gains tax to pay on any capital growth
  • No tax to pay on any income received, either as interest or dividends, from the investment or cash savings
  • You don’t have to declare ISAs on your tax return
  • Access your investments whenever you wish, with no notice period (although it may take up to 10 days for the money to clear into your bank account).
  • There can be a notice period for some cash savings held within an ISA wrapper, but not all. This is dependent on the provider of the cash product – they may offer a special interest rate for a certain period and in return insist savers give notice before withdrawing money.

There are also tax-free allowances for interest earned on savings and from company dividends in investments held outside the ISA wrapper, but they are limited and tax must be paid on amounts above the allowance limit.

Types of ISAs and their allowances

There are currently six different types of ISA.

1. Cash ISA

Anyone over the age of 16 can put their cash savings into a Cash ISA. Accounts can be either instant access, have notice periods or have fixed terms.

The annual allowance for a Cash ISA is £20,000*. You can invest up to this full amount in your Cash ISA, or you can share this allowance between the different types of ISA, with the exception of the Help to Buy ISA.

2. Stocks & Shares ISA

Anyone over the age of 18 can put individual shares or managed funds into a Stocks & Shares ISA.

The annual allowance for a Stocks & Shares ISA is £20,000*. Again, you can invest up to this full amount in your Stocks & Shares ISA, or you can share it between the other types of ISA.

3. Innovative Finance ISA

This ISA is for investments in peer-to-peer lending platforms such as Zopa, Ratesetter and Funding Circle. You must be over the age of 18 to invest.

The annual allowance for an Innovative Finance ISA is £20,000*. Once again, you can invest up to this full amount in your Innovative Finance ISA, or you can spread it out between various types of ISA.

It is important to note that this type of ISA does not qualify for the savings element of the Financial Services Compensation Scheme that protects up to £85,00 per licenced bank. Nor does it enjoy the Financial Services Compensation Scheme investing element that covers up to £50,000 in case your investing platform goes bust and hasn’t done what it is meant to with your money.

4. Help to Buy ISA

This ISA has been introduced to help first time buyers over the age of 18 get on the property ladder. You have to choose between either a Cash ISA or a Help to Buy ISA, but you can have a Help to Buy and a Stocks & Shares ISA in the same tax year.

You can kick start your Help to Buy ISA with a lump sum deposit of up to £1,200*. You can then save up to £200* a month.

For every £200 you save, the government will add 25% up to a maximum bonus of £3,000*. It’s available per buyer, not household, so if you are saving with a partner, the bonus potential is up to £6,000 towards your house deposit.

Another important factor is that the proceeds can only be used to buy a property worth up to £250,000 outside of London and up to £450,000 within London.

5. Lifetime ISA

The Lifetime ISA is similar to the Help to Buy ISA. It is designed to help investors between the ages of 18 and 39 save for either a first house purchase or their retirement. Once you have a Lifetime ISA you can continue to contribute until the age of 50.

You can invest up to £4,000 per tax year into a Lifetime ISA and the government will pay a bonus of 25% on any money saved.

It is possible to hold both a Help to Buy ISA and a Lifetime ISA, but you will not be able to use both bonuses for a first-time house purchase.

Another differentiator between this type of ISA and the Help to Buy ISA is that the proceeds can be used to purchase a property worth up to £450,000 regardless of its location.

6. Junior ISA

Cash or investments can be wrapped in this ISA on behalf of children under the age of 18. Anyone can invest in the Junior ISA – parents, grandparents or friends. The money belongs to the child and they can access it when they reach 18 years of age.

The Junior ISA has an annual allowance of £4,128*.

NB: You must be a UK resident or crown employee to invest in any type of ISA.

How much will it cost?

When deciding on the type of ISA and asset in which you want to invest, it is important to consider the charges involved.

ISA money saved into cash does not incur any initial or annual charges, but ISA money invested into a fund, individual stock or peer-to-peer lending platform does. The type and level of charges vary from provider to provider.

You can expect to pay three different annual charges for fund investment:

  1. A fund management charge
  2. A platform or provider charge
  3. A service charge.

Be aware that some headline charges are not indicative of total costs and it is important to research fees thoroughly to make sure you understand any additional costs you may personally incur.

Learn more: How to choose a fund

What might your returns be?

Even after charges, an investment ISA is likely to produce better returns than a Cash ISA over the long term. Of course, it’s important to understand that investing in funds and stocks is much higher risk than keeping your money in cash, as its value will move up and down, and it is possible to lose money.

This short-term volatility is one very good reason why a longer time frame is usually recommended for these types of investments.

Learn more: Understanding investment risk

Looking at a period of 20 years, here is a simple comparison (without taking into account charges or inflation):

  • A monthly contribution of £500 into a Cash ISA, returning 2% (similar to the best cash rates currently), should give you a pot of money worth £147,644 over 20 years
  • A monthly contribution of £500 into a Stocks & Shares ISA, with 7% gains achieved, would grow your pot of money to £261,982 over 20 years.

What’s right for you?

Choosing between a Cash ISA or an investment ISA such as the Stocks & Shares will depend on the level of risk you are comfortable taking with your money, as well as factors such as how soon you will need to access your money.

If you do opt for cash, picking a Cash ISA product can be fairly simple. The main considerations are interest rate paid, length of time the interest rate is valid, and whether you want instant access or are willing to tie up your money for a fixed period of time.

Selecting investments for a Stocks & Shares ISA is tougher. If you’re considering funds, there are more than 3,000 available in the UK – which is why we started FundCalibre and our Elite Ratings for funds.

Our experienced research team analyses the funds that are widely available to UK retail investors and identifies those which they believe have the most skillful managers.

These funds are awarded an Elite Rating. This rating should in no way be construed as advice. It is solely our opinion. You can use FundCalibre to narrow down your choices and help you select a fund in which to invest.

If you require individual investment guidance you should seek expert advice.

*Figures as at 26 March 2018

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views of the author and any people interviewed are their own and do not constitute financial advice. However the knowledge that professional analysts have analysed a fund or trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to make their own decisions.