In the 2018/19 financial year, 10.8 million ISA accounts were opened. Considering that the total UK population is around 66 million, that’s a lot. By comparison, only 4.2 million in the UK tuned in to BT Sport to watch last year’s Champions League final — which I dare say was more exciting than an individual savings account.
ISAs have become highly popular among UK savers and investors since being introduced 20 years ago. There are various types of ISA, with the most common being cash ISAs and stocks and shares ISAs. They allow an individual to invest up to £20,000 across them each tax year.
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Both cash ISAs and stocks and shares ISAs offer a variety of features that could make them appealing to consumers. Notably, they offer tax advantages and may provide a simple and accessible means of saving and investing.
However, are ISAs a safe means of planning for the future? And if not, how can individuals utilise ISAs to generate high rewards in return for any risk they are taking?
Types of ISA
A cash ISA is akin to a savings account, but with tax advantages: no income tax is payable on any interest received within a cash ISA. This means that an individual can invest up to the maximum amount in each tax year, with their savings never being subject to income tax over the long run.
There is no risk of capital loss within a cash ISA, simply because the cash is not invested in an asset that carries risk.
Should the cash ISA provider go under, an individual would be covered by the Financial Services Compensation Scheme (FSCS) up to a maximum of £85,000. This means it may be wise for individuals with more than £85,000 in cash to have accounts with more than one provider. Since the compensation level applies to a banking group, it is worth checking the parent company of a cash ISA provider, in order to ensure that more than £85,000 is not invested across different providers within the same group. Likewise, not all banks are covered by the scheme, so checking that they are covered could be a sound move.
Stocks and shares ISA
A stocks and shares ISA is a tax-efficient means of investing in a variety of listed companies. Amounts invested through a stocks and shares ISA are not subject to capital gains tax, dividend tax or income tax.
Under the terms of the Financial Services Compensation Scheme, a stocks and shares ISA is treated differently from a cash ISA. For a stocks and shares ISA, the first £50,000 is protected should the provider go under. Note that compensation does not apply to underperforming investments.
A stocks and shares ISA can carry significant risks, depending upon where the money is invested. A variety of assets can be purchased through a stocks and shares ISA; therefore, investors can tailor their portfolios to suit their level of risk tolerance.
For example, an investor who wants to keep risks to a minimum may decide to invest in UK government bonds. They are likely to be considered a relatively safe investment, since the prospect of the government failing, from a financial standpoint, is low. In contrast, an investor with a high level of risk tolerance may decide to buy shares in smaller companies, which by their very nature carry the potential for significant capital losses.
Of course, the more risk an investor takes, generally the higher the return could be. Therefore, it may be prudent to develop a portfolio that includes a mix of cash, bonds and shares.
Having too much of one asset could cause additional risks. For example, too much cash may lead to returns that fail to keep up with inflation. Likewise, too many high-risk shares may cause periods of severe difficulties for an investor, especially during downturns for the stock market.
ISAs should not be considered 100% safe. Even cash ISAs can be risky for investors who do not limit their capital to £85,000 per financial institution. Stocks and shares ISAs can carry a range of risks, depending on an investor’s individual holdings. However, by having a mix of assets, it may be possible for investors to obtain their desired level of risk while also having the potential to generate returns that beat inflation in the long run.