What Is an ISA and How Does It Work?

Individual savings accounts (ISAs) have become a lot more versatile and flexible over the years. 

The amount you can put into an ISA each year and the range of investments you can buy have greatly increased, so many people now use them alongside or even instead of a pension when it comes to funding their retirement plans.

Here’s everything you need to know about an individual savings account.

What is an individual savings account (ISA)?

An individual savings account, or ISA, is simply a special type of savings and investment account designed to protect your money from being taxed.

Think of an ISA as being like a shark cage, with your money floating around inside it completely protected from any encircling tax sharks. An ISA isn’t actually an investment itself, but more of a protective wrapper into which you can put your money.

Please note that tax treatment depends on the individual circumstances of each individual and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.

How do ISAs work?

There are set limits as to how much money you can put into an ISA. These apply to each tax year, which begin on 6 April and ends 5 April the following year.

As long as your money remains in the ISA, you do not have to pay any tax on it. Once you withdraw it, or if you close your ISA account, then it becomes taxable again. In a typical brokerage account, you’d likely pay both income tax and capital gains tax (CGT). Not having to pay these taxes is what makes an ISA beneficial.

Types of ISA accounts

The main types of ISAs are Cash ISAs, Stocks and Shares ISAs, Innovative Finance ISAs, Junior ISAs, and Lifetime ISAs. 

Cash ISA

The simplest type of ISA is a Cash ISA. Any UK resident age 16 or over can open one of these, put up to £20,000 into it each tax year, and pay no tax on any interest they receive. It’s worth noting that changes to the way interest on savings accounts are taxed in recent years have made this tax protection less valuable, particularly for smaller sums. 

Stocks and Shares ISA

Stocks and Shares ISAs protect your money from income tax on dividends received and capital gains tax on any profits you make. You can put up to £20,000 into a Stocks and Shares ISA each tax year.

Once you put the money into a Stocks and Shares ISA, you can use it to buy shares, investment funds, corporate bonds (loans to companies), and government bonds (loans to governments).

Innovative Finance ISA

Innovative Finance ISAs allow you to make peer-to-peer loans, that is, lending directly to people or companies. You can put up to £20,000 into an Innovative Finance ISA each tax year.

Junior ISA

A Junior ISA is designed for parents who want to set up investments for their children. A parent or legal guardian can open a Junior ISA for a child under 18. The savings can be held as cash in a bank or building society, invested into stocks and shares, or a mixture of the two.

You can invest as much as £9,000 per year in a Junior ISA. Once the young person is 16, they can take control of their ISA and can withdraw from it once they turn 18.  

Lifetime ISA

To open a Lifetime ISA , you have to be a UK resident between 18 and 40. You can put up to £4,000 into a Lifetime ISA each tax year. Usefully, once you have already opened one, you can carry on adding £4,000 each tax year until you are 50. You can put the money into cash or stocks and shares. 

Most attractively, the government adds a 25% bonus to any money you put in. The catch is that you can only withdraw money from a Lifetime ISA to buy your first home or once you turn 60. If you withdraw it in any other circumstances, you lose all the government bonus plus a little bit extra on top.

Benefits of ISAs

There are a few main benefits to an ISA:

Double the tax protection

An ISA can protect you from both income tax and capital gains tax (CGT).

Admittedly, the income tax benefits are not what they were when ISAs were first introduced in the 1990s. Basic rate taxpayers usually don’t have to pay tax on any dividends they receive, so you only benefit from income tax protection if you’re a higher-rate taxpayer.

The key attraction of an ISA is the protection from CGT. Although the CGT rate is less than it has been in the past, it may not feel that way if you have to write out a big cheque to the taxman! You do get an annual exemption amount for CGT, but if you’re investing regularly over a number of years, you can soon build up profits far greater than this amount.

Tax rates change

Bear in mind that tax rates change over time, sometimes quite significantly. So although investment income and gains aren’t taxed that harshly at the moment, that may not always be the case. Of course, at some stage the government could even decide to do away with ISAs completely. However, we think that’s unlikely, as that seems a sure-fire vote loser.

So, we believe it pays to protect your investments right from the very start, even if you are investing as little as £25 a month. Most funds and shares can be put in an ISA for no additional charge, so you’re often getting valuable protection at no extra cost. Think of taking out an ISA as (more or less) free insurance against paying tax in the dim, distant future. You may not need it, but it’s nice to have it, just in case.

How much can you put into an ISA?

The ISA allowance for 2022/2023 is £20,000, meaning you can currently put up to £20,000 into a Cash ISA, Stocks and Shares ISA, or Innovative Finance ISA, each tax year. In a Lifetime ISA, you can add up to £4,000 annually. You can pay up to £9,000 per year into a Junior ISA.

How many ISAs can you have?

You can have more than one ISA, but they all count towards the £20,000 annual allowance. That means you could put £10,000 into a Cash ISA and £10,000 into a Stocks and Shares ISA. Remember there is a slightly lower limit for Lifetime ISAs, so another combination might be £8,000 into a Cash ISA, £8,000 into a Stocks and Shares ISA, and £4,000 into a Lifetime ISA.

Another restriction is that you can only put new money into one of each of the four types of ISA each tax year. This means you can’t put money into two separate Cash ISAs in the same tax year, but you are able to have multiple Cash ISAs with different providers that you have built up from previous years.

Finally, it’s worth noting that you are allowed to withdraw and replace money from your ISA during a tax year without the replacement money counting towards your annual ISA subscription limit. This also applies to cash held in Stocks and Shares ISAs.

Therefore, you can put in £20,000, withdraw £5,000 and then put the £5,000 back in again — as long as this is all done within the same tax year.

What happens to your ISA if you move abroad?

Generally speaking, you can only put new money into an ISA if you’re a UK resident for tax purposes. However, you can keep any existing ISAs that you have.

What happens if you die?

Any ISAs you hold form part of your estate and might become liable for inheritance tax. However, when you die your spouse or civil partner can inherit your ISA allowance. What’s more, they can add a tax-free amount up to the value of your ISA when you died or when the ISA was closed as part of the process of administering your estate. 

Is an ISA right for me?

Because of the many tax benefits, an ISA is likely a good idea if you’d like to save money in some way. To determine if an ISA is right for you, check out our featured Stocks and Shares ISA providers in the UK.

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Frequently Asked Questions

Yes, you can have both and you can put money into both in the same tax year. You can put up to £4,000 into a Lifetime ISA and the remainder of your £20,000 total ISA allowance (so £16,000 if you put £4,000 into a Lifetime ISA) into a Stocks & Shares ISA.

Yes, you can put money into one of each of the four types of ISA each tax year. The four types are Cash ISA, Stocks & Shares ISA, Innovative Finance ISA, and Lifetime ISA.

The total amount you put in cannot exceed £20,000 in a single tax year and there is a £4,000 annual limit for Lifetime ISAs.

Yes, you can trade shares either in a Stocks and Shares ISA or within some types of Lifetime ISA.

It will depend on your own personal tax situation but most people who invest on a regular basis or in larger amounts (a few thousand pounds or more) can probably benefit from sheltering their investments within a Stocks and Shares ISA.

The biggest benefit is likely to be when it comes to selling your investments and using the proceeds, although that could be decades in the future.