Individual savings accounts: a beginner's guide
As the 2016/17 Isa season cranks up, investors are faced with more choices than ever - and more opportunity to protect gains and income from the taxman.
From April 2017 there will be six different Isas available to savers and investors. We set out the basic rules regarding Isa types and allowances, and how they can be combined.
WHAT IS AN ISA AND WHAT CAN IT INVEST IN?
An Isa is a tax-efficient 'wrapper' in which savers can hold cash or investments.
These accounts generally make a good starting point for setting money aside, because within an Isa any interest earned on savings is tax-free, while on investments there is no tax due on dividends paid out and no capital gains tax (CGT) when they are sold.
WHAT ARE THE ANNUAL ISA LIMITS?
The rules state that you can set aside up to £15,240 for the 2016/17 tax year, and £20,000 in 2017/18. The annual Isa allowance must be used before the end of each tax year (5 April), otherwise you will lose it.
WHO QUALIFIES FOR AN ISA?
You can open a cash Isa when you turn 16, but for all other types of Isa you have to be at least 18 years old. You also have to be resident in the UK for tax purposes, and you cannot hold an Isa jointly with, or on behalf of, anyone else.
HOW MANY ISA TYPES CAN I OPEN IN A TAX YEAR?
Crucially, it's possible to hold a combination of various Isas, including a cash Isa, a stocks and shares Isa, a Junior Isa and an Innovative Finance (IF) Isa.
However, you can't pay into both a Help to Buy Isa and a cash Isa with separate providers in the same year. Some providers, however, offer split Isas where you have access to both types within the same wrapper.
The Isa family
- building up a rainy day fund
- short-term cash needs
- those over 16 years of age
Cash Isa allowance:
- maximum of £15,240 in 2016/17 and £20,000 in 2017/18
The most straightforward account is the cash Isa, which can hold up to the full value of the allowance and is effectively a tax-free savings account. Your money can be withdrawn at any time to cover emergency costs.
But with effect from April 2016, when the personal savings allowance (PSA) was introduced, the first £1,000 of interest is now tax-free in an ordinary taxable account.
On an easy access account paying 1 per cent that would mean earnings on up to £100,000 of savings were tax-free for basic rate taxpayers; higher rate taxpayers can earn £500 interest with no tax.
Arguably, therefore, the cash Isa has become much less attractive, though if interest rates start to rise significantly, less capital will be needed for interest payments to exceed the £1,000 PSA. However, at the end of December the average cash Isa interest rate stood at just 0.82 per cent, according to Moneyfacts.
One of the reasons people have historically saved into a cash Isa is to build up savings for a first house purchase, but the government bonuses on the Lifetime Isa and the Help to Buy Isa now make these more attractive ways to save for that specific purpose.
HELP TO BUY ISA
- specifically for first-time buyers looking to build up a deposit for a house
- regular cash savers
- over 18s
Help to buy Isa allowance:
- maximum of £1,200 in first month and £200 a month thereafter up to £12,000
- as a result one person can get up to £3,000 in government top-ups
This Isa is specifically for first-time buyers looking to save regularly into a cash account to build a deposit for a property. You can pay up to £1,200 in the first month and £200 a month thereafter, up to a total £12,000; the government adds a 25 per cent bonus when you buy your first home. This means one person can get up to £3,000 in government top-ups.
To qualify for the government bonus, the property bought must be in the UK and must cost up to £250,000 (£450,000 if buying in London). It cannot be a second home or a buy-to-let property.
It can't be rented out after it has been bought, and it has to be purchased with a mortgage. Help to Buy savers are prevented from opening another cash Isa in the same tax year, but they can open a stocks and shares Isa or an IF Isa, and may continue to hold existing cash Isas.
The Help to Buy Isa has been available since 1 December 2015, and new accounts can be opened until April 2019, with additions to existing accounts permitted until April 2029. At the end of December, the average Help to Buy Isa interest rate was 1.98 per cent.
So far the scheme has been very popular, with 350,000 savers signing up already. However, when the Lifetime Isa arrives in April 2017 it is likely to steal the Help to Buy Isa's thunder; indeed investors will be able to transfer existing Help to Buy Isa funds into a Lifetime Isa at that stage.
- investors looking to save for purchasing a first house, or saving for retirement
- people aged 18 to 50 (you have to be under 40 to open the account initially but will be able to top up and get a government bonus up to the age of 50)
Lifetime Isa rules and allowances:
- withdrawals are tax-free, like other Isas, if used to purchase a first property (which can't be worth more than £450,000), or after the age of 60, otherwise there is a 5 per cent charge and the government bonus is subtracted
- maximum of £4,000 per year (£5,000 including the government top-up)
- falls within overall £20,000 Isa limit in 2017/18
The new Lifetime Isa will help younger people save for a house or for retirement. Like a Help to Buy Isa it comes with a £1 government bonus for each £4 saved, but unlike the Help to Buy Isa this is paid at the end of each tax year.
You can save a maximum of £4,000 per year, which rises to £5,000 once the government top-up is included.
Other differences include being able to invest in stocks and shares instead of cash; the Help to Buy Isa can hold only cash. Further, you don't have to save each month - you can put in a lump sum each year.
You have to be aged at least 18 and under 40 to open the account. Top-ups can be made and government bonuses received up to the age of 50.
Withdrawals are tax-free, as with other Isas, if they are used to purchase a first property (which can't be worth more than £450,000), or if they are made after the age of 60; otherwise there is a 5 per cent charge and the government bonus element is subtracted (but not in the first year of its introduction).
STOCKS AND SHARES ISA
- investing to meet medium-term goals like children's university fees
- investing for retirement
- investing in retirement
- those over 18 years of age
Stocks and shares Isa allowance
- maximum of £15,240 in 2016/17 and £20,000 in 2017/18
The stocks and shares Isa is a stalwart of medium- and long-term investment because it is very flexible and can potentially ringfence much larger gains from the taxman.
It is available to everyone over the age of 18, and money can be withdrawn tax-free at any time. This makes it suitable for saving for numerous purposes, including school and university fees, mortgage repayment or retirement.
The new £20,000 Isa allowance from 2017 will help those who want to save sizeable chunks for their future while sheltering their investments from UK income and CGT.
Retired investors can also make use of stocks and shares Isas to squirrel away excess income, and/or to reinvest their pension tax-free lump sum to boost their annual income. Importantly, there is no risk of Isa income pushing them into a higher tax bracket, because it is tax-free and need not be declared.
'People who are prepared to take some investment risk and put money away for at least five years should ensure they get a stocks and shares Isa,' says Ray Tammam, a financial adviser at advisory firm Fairstone.
If you are ready to open a Stocks and Shares Isa please consider Interactive Investor, our sister site and award winning brokerage.
- under 18s only
- building up savings for a child for university fees and costs, house deposit, gap year, first car or other large spending needs
- conversion into an adult Isa
Junior Isa rules and allowances:
- can accept transfers from Child Trust Funds
- £4,080 allowance available to children from birth up to the age of 18
The baby of the family, the Junior Isa (Jisa) is a £4,080 allowance available to children from birth up to the age of 18, which automatically converts into a 'grown-up' cash or stocks and shares Isa at age 18.
The Jisa has proved popular with families looking to build up a nest egg for their children, and may be used to save for university fees and costs, a house deposit, gap year, a first car or other major expenses. Jisas can accept transfers from child trust funds.
INNOVATIVE FINANCE ISA
- income seekers willing to take risk
- over 18s
Innovative finance Isa allowance:
- maximum of £15,240 in 2016/17 and £20,000 in 2017/18
Since April 2016, investors have been able to invest in peer-to-peer loans and crowdfunding debt securities within an Isa, thereby receiving interest from these loans tax-free.
However, many of the biggest peer-to-peer platforms such as RateSetter and Zopa are still waiting to be authorised to offer the IF Isa.
The Innovative Finance Isa will appeal to those looking for higher rates of interest than is available on cash and government bonds, and willing to take on the additional risks associated with lending directly to companies and individuals. Investors can allocate their full allowance to an IF Isa if they wish.
Isa transfers and switches
It has been possible to switch freely between cash and stocks and shares since July 2014.
In practice, if you want to transfer from cash to stocks and shares, you will probably have to move your account to a separate equity-based provider such as a fund platform, because few cash Isa providers have a linked broker.
It should be relatively straightforward, if you want to move your money out of the stock market on a temporary basis, to hold cash for a while before moving back into the market. That's because most fund platforms and brokers have a tax-free 'cash park' in place for short-term use.
With effect from April 2016, Isa investors can also withdraw cash altogether (for a short-term project or to bridge a temporary cash flow problem, for instance) and put it back into their Isa without affecting their allowance, as long as the withdrawal and subsequent deposit are made in the same tax year.
This additional flexibility can apply to both cash Isas and to cash held in a stocks and shares Isa; but it is offered at the Isa provider's discretion.
If you hold shares or funds in a taxable investment account, you can sell them and reinvest the proceeds in an Isa. This is known as 'bed and Isa'.
This way you can use existing money or investments to take advantage of annual tax allowances, rather than having to find new money to invest. The holdings are sold in one transaction, and then bought back within the Isa wrapper in another.
THREE PITFALLS TO AVOID IN ALLOCATING AND MANAGING YOUR ISA
Not having an overall investment strategy
'Any decision about where to invest and where to allocate the money should be investment-led, not tax-led or product-led.
'The main focus should be on making sure your Isa is aligned with your total investment strategy, and more importantly also aligned with your overall financial planning. In many cases it may not be,' says Craig Palfrey, chartered financial planner at Penguin Wealth.
Investing in an Isa through an investment platform suchas Interactive Investor, Money Observer's sister website, is the most cost-effective route.
Investment supermarkets give you access to a wide range of investment fund brands in one place. Isas purchased this way are also generally cheaper than if they are bought direct from the fund manager.
Neglecting your pension
'Pension contributions receive a top-up via tax relief; even non-earners can contribute up to £2,880 which will be topped up to £3,600,' says Simon Torry, a planner at SRC Wealth Management in Basildon.
Non-taxpayers' withdrawals are tax-free and the 25 per cent tax-free lump sum means that for most retirees (even if their tax status has not changed) the net return should be better than that from an Isa.