This means that, if your account is paying 2.00%, as a basic rate taxpayer (20%) you will actually only receive 1.60%, and as a higher rate taxpayer (40%), you will receive 1.20%. Additional rate taxpayers (45%) will only get 1.1%.
But one way to ensure the taxman keeps his mitts off your cash as much as possible is to invest in an individual savings account (ISA) as you won't have to pay income tax on the interest you earn – so if your ISA pays 2.00%, you'll receive the full 2.00%.
This means an ISA should always be your first port of call when it comes to stashing away some of your funds.
Types of ISA
There are two different types of ISA – a cash ISA and a stocks and shares ISA. You can invest in just one of these options, or you can invest in both.
Cash ISAs are very similar to standard savings accounts, apart from the fact you don't pay tax on the interest you earn. You can choose from an easy access cash ISA or a fixed rate cash ISA.
Stocks and shares ISAs are more risky as you invest your money on the stock market. But this also means you can potentially earn a greater return on your money. You can put a variety of investments in a stocks and shares ISA such as individual company shares, investment trusts, bonds, open ended investment companies (OEICs), exchange traded funds (ETFs) and unit trusts.
With a stocks and shares ISA, you won't pay tax on any profit you make on your investments. However, you will pay tax on dividends paid by shares in an ISA as they are automatically taxed at source at a rate of 10%.
Each tax year you will be given a new ISA allowance (the maximum you can pay into your ISA in that particular tax year). In the current tax year, which runs until April 5, 2014, you can invest a total of £11,520 into an ISA. The full allowance can be invested in a stocks and shares ISA, but only half (£5,760) can be paid into a cash ISA.
Bear in mind that, if you have a cash ISA and invest the full allowance, but then withdraw some of your funds, you can't top it back up again to the full amount.
You should also note that some cash ISAs allow you to transfer funds in from any existing cash ISAs you might have (this doesn't form part of your annual allowance). But if you are transferring funds, don't withdraw the money to transfer yourself as it will lose its tax-free status. Instead, tell your new provider you wish to transfer funds from an existing ISA and fill in a transfer form.
You can transfer money from a cash ISA into a stocks and shares ISA but you can't transfer funds invested in a stocks and shares ISA to a cash ISA. However, you can still alter your underlying investments in a stocks and shares ISA and you won't lose the tax break.
Which ISA is right for me?
Ask yourself whether you want to invest in a straightforward cash ISA or whether you're prepared to take more of a risk with a stocks and shares ISA. If you're unsure, you might want to invest in both.
If you're sticking with cash, you'll then need to decide whether you'd prefer to pay into your account and access your funds whenever you want to, or whether you have a lump sum to invest which you'd like to leave untouched for a year or so.
Should you need to access your money, opt for an easy access cash ISA. These accounts can often be opened with £1 and you can top up your savings as and when you choose to, providing you don't go over your annual allowance of £5,760.
Watch out, though, because some easy access cash ISAs will still limit the number of penalty-free withdrawals you can make in a year. Remember too that easy access cash ISAs usually have variable interest rates so they can change at any time. Some also include a temporary bonus rate – and once it ends (typically after 12 months) the interest rate will drop, you'll need to find a new, more competitive home for your money.
If you're happy to lock your money away, and you have a lump sum to invest, a fixed rate cash ISA will be more suitable. You will usually get a higher rate of interest, and the rate is fixed for the term of the bond so you'll know exactly how much interest you will earn. However, you must leave your money untouched for between one and five years, and you can often only make one deposit when the account is opened, so they are no good if you want to save regularly.
If you feel comfortable taking more of a risk and you decide to invest in a stocks and shares ISA, it's worth talking to an independent financial advisor (IFA), particularly if you're new to investing. They should be able to help you decide which investments suit you best (you will have to pay for this advice).
Remember that investing is for the long-term so be prepared to put your money away for at least five years to give yourself a chance of regaining any falls that might be made. You stand to earn a bigger return if you put your money in higher risk investments, but they are also more volatile, so you could lose more.
Whichever option you choose, you can compare a wide range of ISAs at MoneySuperMarket.
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