The tax breaks offered by ISAs make them hands-down the best way for most people to save. Not everyone knows how ISAs work, though. So we’ve written this short guide to explain everything you need to know about these tax-efficient savings accounts.
ISAs: A definition
ISAs (or Individual Savings Accounts to give them their full title) differ from standard savings accounts in that they do not charge tax on the interest you earn – up to an annual limit.
This is because the money invested in an ISA is held in a so-called “wrapper” that protects it from the taxman.
For higher-rate taxpayers, this means avoiding income tax at 40% on any savings interest, while for savers in the basic-rate tax band it provides a saving of 20%. Those few paying additional rate tax, meanwhile, will avoid tax on interest at 45%.
If you have money invested in a cash ISA, you can also move it into a stocks and shares account
If you have money invested in a cash ISA, you can also move it into a stocks and shares account and vice versa.
For those who choose to invest in a stocks and shares, rather than a cash, ISA, there is also no Capital Gains Tax to be paid on any profits.
Higher and additional rate taxpayers with stocks and shares ISAs also pay a lower rate of tax on their dividends: 10% rather than up to 42.5%.
How much to invest
For this tax year (which ends on April 5, 2015), the total ISA allowance per adult is £15,000.
You can invest the full allowance into a cash ISA if you want, or you can invest it in stocks and shares, or a combination of the two. Junior ISAs, which replaced the Child Trust Fund in 2011, can hold up to £4,000 this tax year and the money can be split between cash and stocks and shares, or invested in just cash or just stocks and shares
When and how to invest
Whether you want to invest in a stocks and shares ISA, in a cash ISA or in both, the only way to cash in on the tax breaks available is to do so before the end of the tax year on April 5. Otherwise, your allowance will be lost forever and any money paid in will count towards your allowance for the next tax year.
The same is true of any money paid into your cash ISA and then withdrawn. So if you paid the maximum £15,000 into your account and then withdraw £1,000, you will not be able to pay any more in before the end of the tax year due to this rule.
Different kinds of ISA
You can open one cash ISA, and one stocks and shares ISA each tax year. However, the total amount invested must not exceed your ISA allowance of £15,0000, As long as you stick to this limit, you can then choose between cash ISAs offering easy access to your money and variable rates of interest and those that lock in your money for a pre-set term at a fixed rate, as well as a range of funds and assets that can be held within a stocks and shares ISA.
For qualifying children, parents can also invest in a Junior ISA that will be free of tax until the child reaches 18 and the money becomes theirs. Bear in mind these accounts are always held in the child's name.
Splitting money between cash and stocks and shares ISAs
It is possible to invest the full £15,000allowance in a stocks and shares ISA, within which you can choose from a range of underlying investments such as unit trusts, investment trusts, open ended investment companies, bonds, individual shares and exchange traded funds.
If you have money invested in a cash ISA, you can also move it into a stocks and shares account and you can also transfer money from a stocks and shares ISA into a cash ISA.
Switching savings to a better deal
Yes, you can transfer money invested either this year or in previous tax years between both cash and stocks and shares ISAs without losing the tax-free status.
However, it is crucial not to physically withdraw the funds as this will result in you losing the tax breaks, just as you would if you withdrew a sum of money from your cash ISA for example.
Rather than closing your existing account and then searching for a better deal, you must therefore find a new account first and arrange a transfer with the bank or investment company providing it.
Savings providers will start unveiling their ISA deals as the new tax year approaches – MoneySuperMarket’s ISA channel is the perfect place to stay up to date with these.
Remember, though, that not all ISA providers accept transfers from other accounts.