A guide to ISA types, and how they can facilitate your financial goals
As part of our ISA special this year, we wanted to provide a helpful guide to those wanting to understand how they work, and where they can sit within a wider financial plan. In 2020, you have more flexibility and choice with Individual Savings Accounts than ever before, so it pays to know how each one works and how to leverage the benefits to achieve more tax-free savings if you’re in a position to make use of them.
Both a regular savings account and an ISA can be opened at a local high street bank (although the latter can be used elsewhere). Whilst the former is a useful place to store easily-accessible cash, an ISA allows you to benefit from important tax advantages. Not only is any interest generated on your money tax-free, but any investment income/gains are also free from tax as well (e.g. capital gains and dividend income).
The important condition in 2020-21 is that you are only allowed to commit up to £20,000 per tax year into your ISA(s). In addition, there are various types of ISA intended to address specific purposes, which we will turn to now.
This type of ISA is most similar to a regular savings account, as it allows you to withdraw as much as you like, at any time. In 2020, there isn’t a noticeable difference between the two with regards to which one pays the higher interest rate. However, one important difference is that any interest earned within your Cash ISA does not count towards your tax-free personal savings allowance (which allows Basic Rate taxpayers to earn up to £1,000 interest each tax year without facing tax).
Consider for a minute that a Higher Rate taxpayer will likely pay £40 tax for every £100 interest earned over their personal savings allowance (£500). This can lead many people to still favour using a Cash ISA for easy-access cash, even in cases where the interest rates are lower than a regular savings account.
Launched on the 6th April 2017, the Lifetime ISA (or LISA) allows you to save up to £4,000 per tax year. For every £4 committed the government will also contribute £1, providing a maximum £1,000 “top-up” each financial year. Over ten years, for instance, this makes it possible to attain a £10,000 bonus from the government assuming you keep saving the full amount. This all occurs apart from the interest and growth which will likely also occur within your LISA, which are free from tax.
The primary condition of the LISA is that any savings must be put towards buying a first home, or towards retirement (i.e. the money is locked away until you reach age 65). The 25% bonus is granted to your LISA savings until you reach age 50, and provided the rules remain unchanged the maximum bonus available is £33,000.
Be careful to note that a 25% penalty is incurred if you use your LISA savings for anything other than a first home purchase or for retirement. This withdrawal charge is not applied in tragic situations; i.e. if you die or are diagnosed with a terminal illness (with less than 12 months to live). However, the LISA rules do allow you to contribute to both a LISA and other types of ISA, and you’re allowed to move it to another provider if you find a better deal.
Each person is entitled to their own LISA. So if you’re married or in a relationship, you can have one each and combine the benefits! You must have had the LISA open for a minimum of 12 months before you can use the savings towards a property purchase, and the property must be valued at under £450,000.
It’s also a good idea to consult professional financial advice if you’re considering using a LISA to facilitate your income in retirement. Quite often a pension will be regarded as a better option, since LISA savings are made from net (after-tax) income; whereas pension contributions come from pre-tax income and are often boosted by employer contributions. However, a pension cannot be withdrawn early whilst LISA savings can be in the case of critical illness. Also, you are only allowed to take up to 25% of your pension as a tax-free lump sum from the age of 55. Under LISA rules, you have to wait a bit longer (i.e. until age 60) but withdrawals from LISAs are completely tax-free.
Looking to build up a tax-efficient set of savings for your child? If so, one option is to set up a Junior ISA on your child’s behalf (see our piece on Planning Your Life Journey), which allows you to commit up to £9,000 per tax year, tax-free. The Junior ISA comes in two forms - a Cash ISA (much like an ordinary Cash ISA) and the Stocks & Shares Junior ISA, which allows your child’s savings to be invested.
The account can be built up until your child reaches age 18, and the interest rate on the Cash ISA can be respectable with some providers offering up to 3.6%.
The rules were also updated in 2015 to allow people with a child trust fund to convert it into a Junior ISA (NB. the rates on the former tend to be lower).
So, be careful to have sufficient emergency savings outside of this account if you want to contribute to one. Also, please note that any unused allowance for the tax year (i.e. £9,000) is lost if you do not use it, so make sure to fully take advantage of it before the 5th April.
An ISA doesn’t simply need to be about finding a tax-efficient place to store easy-accessible cash. You can also use it as an investment wrapper via a Stocks & Shares ISA. Here, you can invest in different funds, bonds and shares, and your ISA will be managed by an online platform or broker. Any capital gains or investment returns you make within your ISA(s) will be tax-free (although as always you should note that investments can go down as well as up)..
It’s a good idea to seek professional advice about finding the best deal if you are interested in investing through an ISA. Remember, the brokers/platforms which facilitate them charge fees for opening and keeping a Stocks & Shares ISA, and some will even charge you if you want to take money out, move capital across to another company or alter your investment set.
Some higher earners might be interested in generating a return by lending money to other people or to businesses. Here, an Innovative Finance ISA could be an attractive option, since it allows you to engage in crowdfunding, peer-to-peer (P2P) lending and business lending whilst reaping returns and interest tax-free.
Bear in mind, however, that whilst your Innovative Finance ISA money might be protected from tax, it isn’t protected from risk. This type of investing, moreover, is widely regarded as higher risk due to the possibility that borrowers might default, or make late repayments. By seeking expert advice, however, you can help to mitigate these risks by diversifying your investments across a range of loans, thus shielding your portfolio in case one of your borrowers fail.
These are now closed to new applicants in 2020, but there are some important need-to-knows for people who already have a Help-to-Buy ISA. These ISAs used to allow you to commit £1,200 within your first month of opening it (£200 a month thereafter), and the government would provide a 25% “top-up” to your savings when you eventually used them towards a property purchase.
For those looking for a similar scheme, the Lifetime ISA outlined above will likely be of interest to you (since Help-to-Buy ISAs stopped selling to new customers on the 30th November 2019). If you currently own one, however, please note that you can only continue saving up to £200/mth into it until November 2029. Also, be careful not to forget that the 25% Help-to-Buy ISA bonus only applies to the deposit at completion (i.e. the mortgage deposit).
For the initial exchange deposit during the earlier stages of buying a property, you will need to rely on your own savings.
Also, be careful to note that if you have paid into a Help-to-Buy ISA during the present tax year, you will not be prohibited from also putting money into a Cash ISA. If you want to withdraw your money from your Help-To-Buy ISA then you can do so, but be aware that the 25% bonus will be withdrawn.
Finally, if you want to transfer your Help-to-Buy ISA to another provider to try and find a better rate, there are still some brands which allow this (even if these ISAs are no longer available on the wider market).
Contact us for guidance on which ISA might be right for you and your circumstances.