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Retire wealthy: Cash ISA vs stocks and shares ISA

If you’re yet to use up your ISA allowance for this year, you’re likely to face a decision over whether to go for a cash ISA or a stocks and shares one.

Risk-Return trade-off

Cash ISAs are simple — they work in much the same way as an ordinary savings account, except they allow you to earn interest without being liable for income tax. You get the security of regular interest, but if the inflation rate is higher than the interest rate you receive, then the spending power of your savings may be eroded.

Over the longer term, investments in the stock market typically produce better returns than cash, often in excess of the inflation rate. However, this comes at a trade-off in the form of added risk — the value of your investment in a stocks and shares ISA can fall, as well as rise, depending on the performance of your investments.

Investment time frame

Choosing between funding a cash ISA and stocks and shares ISA should depend on your investment goals and your own personal circumstances. Generally speaking, if you’re planning to withdraw your investments within the next five years — say for a deposit on a new home, debt repayments or personal expenses, then a cash ISA will usually be a better choice — it is, at the very least, the safer choice.

On the other hand, if you are saving up for retirement which may be decades away, stocks may be better. Although they are riskier — over longer time periods, stocks have a decent track record of growing your capital.

Tax allowances

Personally speaking, given that I don’t expect to use up my personal savings allowance — which is currently £1,000 in interest income per year for basic-rate taxpayers, £500 for higher-rate taxpayers and £0 for additional-rate taxpayers, I would stick with just a stocks and shares ISA.

That’s not to say that I would avoid cash entirely. Emergency cash is an essential part of everyone’s financial plan — this is the money you set aside for unexpected expenses. I would just keep it outside of the ISA, unless I had some unused allowance in a given tax year.

With expected returns likely to be higher for equity investments, the tax benefit of a stocks and shares ISA can often be greater than that of a cash ISA. But which has the bigger benefit to you personally depends ultimately on your own personal circumstances and investment returns. For instance, if you’re a (very) big cash saver or an additional-rate taxpayer, a cash ISA may well give you a greater tax benefit in some years. And there are also the dividend and capital gains tax allowances to consider.

Transfer

If you’re still torn between the two ISAs, then why not consider getting both. There’s nothing stopping you from doing this, and you can decide to move money between the two at a later stage (of course, tax rules may change). Just make sure that you ask your new ISA provider to arrange the transfer, otherwise you may lose the tax-free status of your investments.

That’s because, if your make a withdrawal from your ISA, you don’t reset your annual subscription limit. And remember, there’s a maximum subscription allowance of £20,000 in a tax year, which you can split across all types of ISAs.

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Jack Tang has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.