What is an ISA?

An ISA (individual savings account) is a tax-free savings vehicle. The fact that returns are tax free is a big advantage, as investments held outside an ISA wrapper are liable to income or capital gains tax. Please note that the tax treatment depends on your individual circumstances and may be subject to change in the future.

There are two types of ISA: cash ISAs and stocks and shares ISAs.

Do I qualify for an ISA?

Every adult in the UK is allocated an ISA allowance each tax year. The tax year runs from 6 April to 5 April - if you don't use your annual allowance during that time, it is lost forever. You can't carry it over to the following year.

For the greatest tax savings, it therefore makes sense to invest the maximum each year - and watch your tax-free nest egg build up with time. 

How much can I invest?

Your annual ISA allowance in the 2013-2014 tax year is £11,520. You can put the entire amount in a stocks and shares ISA. Alternatively, you can split it and put up to 50% - £5,760 – in a cash ISA. Remember though, the total you can invest this year is £11,520 so if you put more than £5,760 in a stocks and shares ISA it will reduce the maximum you can put in cash. For example, if you invest £7,000 in stocks and shares, you’ll only be able to put £4,760 in a cash ISA.

The tax year ends on 5 April 2014. If you haven’t used your 2013-2014 ISA allowance by then you’ll lose it.

How many ISAs can I have?

You can open one cash ISA, and one stocks and shares ISA each tax year.

Your annual allowance can be split 50:50 so half goes into a cash ISA while the other half can be invested in a stocks and shares ISA.

Alternatively, your full allowance can be invested in a stocks and shares ISA. The ISA is effectively a tax wrapper like a pension, so you can choose the underlying investments your money is invested in. Various non-cash assets can be held in a stocks and shares ISA, including unit trusts, investment trusts, open ended investment companies, bonds, individual shares and exchange traded funds.

Rule changes introduced in 2008 also mean that you can move money held in existing cash ISA into a stocks and shares ISA and retain the tax break. However, you can't transfer money from stocks and shares into a cash ISA.

ISAs are aimed at encouraging people to invest for the longer term - as soon as you make a withdrawal from an ISA you lose the tax-free status on that money. Therefore, if you need to dip into your savings, use funds held in non-ISA accounts first.

What is the difference between a cash ISA and a Stocks and Shares ISA?

Cash ISAs are like any other standard savings account, but with one fundamental difference: you don't pay tax on any interest you earn. Normally, basic-rate taxpayers pay 20% on any savings interest, while those in the higher-rate tax band pay tax at 40%, and anyone earning more than £150,000 a year pays 45%. Therefore, if you are a taxpayer, it is well worth making use of your annual ISA allowance.

Stocks and shares ISAs are also tax-free, they are a way of putting money into a wide range of investments without having to pay tax on the profits your make. You can put your money into a range of investments, including unit trusts, open ended investment companies (OEICs), investment trusts, exchange traded funds, individual shares and bonds. With a stocks and shares ISA your capital is at risk. The value of your investment and the income derived from it can go down as well as up and you may get back less than you originally invested.

Are all cash ISAs the same?

No. Cash ISAs are like any other savings account and there are a number of different types - easy access, fixed rate and notice accounts.
 
When comparing cash ISA deals, there are several things to bear in mind. As with standard savings accounts, fixed rate deals tend not to allow more than one investment. You can also not usually access your money during the fixed term.

And many of the leading easy access accounts include introductory bonuses so the account may lose its competitiveness once that ends - you should be aware of this and be prepared to move your money again at that point.

Is a stocks and shares ISA suitable for me?

The advantage of investing in a stocks and shares ISA is that you can shelter more money from the taxman than if you just put your money in a cash ISA. The reason for this is that the government wants to encourage more people to invest in equities because, over time, they tend to produce higher returns than cash. And obviously, the more money individuals can save for their own futures, the less reliant they'll be on the state.

However, there is more risk attached to a stocks and shares ISA because stock markets can go down as well as up, so you could lose money.

Financial advisors therefore only tend to recommend that you use a stocks and shares ISA if you have money you are looking to invest for at least five years. That way you should be able to ride out dips in the stock market. Having said that, even then there is no guarantee, so if you are totally risk averse, a stocks and shares ISA probably isn't for you.

It is also important to understand that there is a huge variation in the types of investment you can hold within a stocks and shares ISA - some are more risky than others and returns will vary significantly.