However, millions of people miss out on this valuable tax break each year because they don’t really understand what ISAs are and the benefits they offer.
Here we explain how they work...
What is an ISA?
An Individual Savings Account (ISA) is a tax-free savings vehicle. You can keep your money in cash within an ISA or invest in non-cash assets such as shares and bonds, but the fact it is held within an ISA means your returns won’t be liable to income tax or capital gains tax.
You pay income tax on interest you earn from a standard cash savings account. This means higher-rate taxpayers lose 40% of their interest (those in the top tax band lose 50%), while basic-rate taxpayers pay 20% income tax. Putting your savings in an ISA therefore gives a significant boost.
Returns on non-cash investments are taxed differently as they are liable to capital gains tax which can be up to 28%.
How much can I invest?
Until April 5 this year, you can invest £10,680 into an ISA, of which a maximum £5,340 can be kept in cash.
From April 6, however, the annual ISA investment allowance will be raised to £11,280, up to £5,640 of which can be saved in a cash ISA.
The remainder of the £11,280 can be invested in a stocks and shares ISA with either the same or a different provider.
But if you don't make use of your full ISA allowance, it will be lost. You cannot roll it over to the next tax year.
And once you have invested money into a cash ISA, you must leave it there if you want to benefit from your full allowance for any one tax year.
If you withdraw cash and your overall balance falls below the limit, you will not be able to top the fund up again, as you are already considered to have benefited from tax advantages on the cash you paid in and then withdrew.
What are the different sorts of ISAs?
As long as you stay within the given limits, you can open one cash ISA, and one stocks and shares ISA each tax year.
As indicated, only up to half of your allowance can be put into a cash ISA. This is like a tax-free version of a standard savings accounts offering easy-access and a variable interest rate or a fixed rate for a term set at the outset.
If you want to take full advantage of your ISA allowance for the year, then the remainder can only be invested in a stocks and shares ISA, which allows you to invest in a range of non-cash assets.
You do not have to split your ISA allowance between cash and other assets, though.
It is also possible to invest the full amount in a stocks and shares ISA, within which you can choose the underlying investments your money is invested in (just as you can with a personal pension).
Assets that can be held in a stocks and shares ISA include unit trusts, investment trusts, open ended investment companies, bonds, individual shares and exchange traded funds.
To compare the options, take a look here.
Can I switch between cash and equities?
You can move money from a cash ISA into a stocks and shares ISA, but you can't switch from equities to cash.
Can I transfer money I have invested in previous tax years?
It is possible to transfer money invested in previous tax years between both cash and stocks and shares ISAs without losing the tax-free status.
However, you need to be careful. If, for example, you close your existing cash ISA and then look to move the money into another account you will lose the tax breaks just as you will if you withdraw a sum of money from the account.
You must therefore arrange a transfer with the provider to which you want to move.
As not all accounts will accept transfers in, this is something to bear in mind when comparing deals, as is the fact that some providers charge you an exit fee to take your money elsewhere.
Where can I find the best cash ISAs?
One of the best easy-access ISAs currently available is the Nationwide Online ISA.
It offers a headline interest rate of 3.10% (including a 2.10% bonus that runs until January 31, 2013).
However, you will need to invest £25,000 to benefit from this rate – savers with between £1,000 and £24,999 earn just 2.75%.
Fortunately, the ING Direct Cash ISA is currently paying 3% (guaranteed for three months) on balances of £1 and above. It also offers instant access to your cash should you need it.
If, on the other hand, you are able to lock your cash away, Halifax’s two-year ISA Saver Fixed pays 3.70% on £500 or more.
You can make no additional deposits or withdrawals during the two-year term and you will forgo 180 days of interest if you need to close the account.
The good news for people with ISA savings from previous tax years, however, is that Halifax does accept transfers from other providers.
You can also get the same rate with the NatWest Fixed Rate ISA lasting for three years, as long as you have at least £1,000 to invest. It too accepts transfers but does not allow any withdrawals and penalises early closure.
Please note: Any rates or deals mentioned in this article were available at the time of writing. Click on a highlighted product and apply direct.