Understanding ISA investment basics

Sarah Culver 26/08/2017 in Basics

What is an ISA?

Individual Savings Accounts – known as ISAs – are tax-efficient wrappers for savings and investments.

They were introduced in 1999 and help maximise returns by shielding your growing pots of money from income and capital gains tax.

There are four types of ISA for adults: cash ISAs, stocks and shares ISAs, innovative finance ISAs, and Lifetime ISAs. Money can be put into each kind of ISA during a tax year, although age limits do apply.

There are also Junior ISAs for those aged under 18. Although they are opened by parents or those with parental responsibility, the money belongs to the child.

Quite simply, if you have cash savings or are investing, there is no reason not to use an ISA wrapper.

How much can I put in an ISA?

The Government sets the maximum that can be invested in ISAs during each tax year, which runs from April 6th to the following April 5th.

This figure is known as the annual ISA allowance, and it is currently a maximum of £20,000 for adults. The Junior ISA investment limit is £9,000-a-year.

However, it’s a case of ‘use it or lose it’. Any part of these allowances that’s unused after April 5th can’t be carried over to the next tax year.

Should I use an ISA?

Their tax advantages definitely make ISAs worth considering. 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
  • You don’t have to declare ISAs on your tax return
  • Access to your investments whenever you wish – although notice periods may apply on some cash ISA products.

There are tax-free allowances for interest earned on savings and from company dividends in investments held outside an ISA. However, investment limits apply, over which tax will be due.

The Personal Savings Allowance also enables basic rate taxpayers to earn up to £1,000 in interest without paying any tax on it. Higher rate payers can earn up to £500.

This has the effect of removing the tax advantages of cash ISAs for many people as they’re unlikely to be earning such high levels of annual interest – unless they have very substantial savings pots.

However, it may still be worth making the most of your ISA allocation by holding it in a cash ISA paying a decent amount and then moving it into a stocks & shares ISA at a later date.

How to become an ISA millionaire

Do you dream of having a seven figure portfolio? Well, this is possible – depending on how much you invest, the timescale, and the performance of your investments.

There are around 2,000 ISA millionaires, according to documents released by HMRC after Freedom of Information requests from InvestingReviews.co.uk.

Types of ISAs

Cash ISAs

You must be at least 16-years-old to open a Cash ISA. These accounts are offered by a wide variety of banks and building societies.

The interest rate on offer will vary between providers. While some offer instant access to savings, others require notice periods, usually in exchange for paying slightly more.

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.

Stocks & Shares ISAs

You need to be at least 18-years-old for a stocks & shares ISA. Investments can include company shares, unit trusts and investment funds, corporate bonds, and government bonds.

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.

Innovative Finance ISAs

This ISA is for investments in peer-to-peer lending, via platforms such as Zopa or RateSetter. Once again, you need to be at least 18-years-old to invest.

The annual allowance for an Innovative Finance ISA is £20,000. 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 £85,000 in case your investing platform goes bust and hasn’t done what it is meant to with your money.

Lifetime ISAs

Is it too late to open a lifetime ISA? Well, it depends on your age.

These are designed to help investors between the ages of 18 and 39 save for a first house purchase or their retirement. Once you have a Lifetime ISA you can continue to contribute until the age of 50.

Up to £4,000 per tax year can be invested into a Lifetime ISA and the government will pay a bonus of 25% on any money saved. The proceeds can be used to purchase a property worth up to £450,000.

Junior ISAs

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 current allowance is £9,000 per tax year.

How much does it cost to invest?

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.

Charges levied on stocks & shares ISAs are often overlooked but they can make a huge difference to the returns generated.

Investment companies levy various fees for managing your portfolio and making changes to the holdings – and these can mount up.

Remember that headline charges are not indicative of total costs. Therefore, it’s vital to research fees thoroughly and ensure you understand additional costs that may apply.

There are three main annual charges to pay:

  • A fund management charge
  • A platform or provider charge
  • A service charge.

How much can you make?

An investment ISA is likely to produce better returns than a cash ISA over the longer term. However, this ride will also be volatile.

Investing in funds and stocks is much higher risk than keeping your money in cash, as its value will move up and down. It’s also possible to lose money.

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

Learn more: Understanding investment risk

We examined a 20 year period to illustrate the point. For the benefit of simplicity, neither account charges nor inflation were considered.

A monthly contribution of £500 into a Cash ISA, returning 2%, should give you a pot of money worth £147,644 over two decades.

However, monthly contribution of £500 into a stocks & shares ISA, with 7% gains achieved, would grow your pot of money to £261,982 over this period.

Of course, as mentioned above, there are no guarantees when it comes to investing.

Cash ISA or Stocks and shares ISA – which option is best for you?

What’s right for you? This will depend on your personal circumstances, savings and investment goals, and attitude to risk.

If you owe money then it’s sensible to clear your debts first. This is particularly important if you’re paying high rates of interest as these will usually be more your ISA will provide.

It’s also important to have money set aside – in an instant access cash ISA – for use in an emergency.

Choosing a cash ISA is 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.

A stocks & shares ISA is ideal if you’re looking to invest for the longer-term. However, selecting investments is more of a challenge.

If you’re considering funds, there are thousands 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 skilled 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.

This article is provided for information only. The views of the author and any people quoted are their own and do not constitute financial advice. The content is not intended to be a personal recommendation to buy or sell any fund or trust, or to adopt a particular investment strategy. 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.Past performance is not a reliable guide to future returns. Market and exchange-rate movements may cause the value of investments to go down as well as up. Yields will fluctuate and so income from investments is variable and not guaranteed. You may not get back the amount originally invested. Tax treatment depends of your individual circumstances and may be subject to change in the future. If you are unsure about the suitability of any investment you should seek professional advice.Whilst FundCalibre provides product information, guidance and fund research we cannot know which of these products or funds, if any, are suitable for your particular circumstances and must leave that judgement to you. Before you make any investment decision, make sure you’re comfortable and fully understand the risks. Further information can be found on Elite Rated funds by simply clicking on the name highlighted in the article.