What Is an ISA?

The what, why and how of Individual Savings Accounts

Alanna Petroff 11 March, 2013 | 6:00AM
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This article is part of the special series, Investing with ISAs.

What Is an ISA?
An ISA is an individual savings account. British residents use ISAs to avoid paying tax on money held within these accounts. You can hold cash, shares, funds, investment trusts, ETFs and/or bonds in an ISA.

The main benefit of having an ISA is that your money is more or less immune from taxes. You avoid paying income tax on interest and dividends, and you avoid paying capital gains tax on portfolio gains.* ISAs were created by the government in 1999 to promote a savings culture in the UK.

There are two kinds of ISAs: a cash ISA and a stocks and shares ISA. A cash ISA will, predictably, hold cash. Cash ISAs available for investors generally offer a set interest rate, so you know that, for example, if you put £1,000 in a cash ISA offering a 3% interest at the beginning of the financial year, this will have increased to £1,030 at the end of the year.

Meanwhile, a stocks and shares ISA is designed to hold stocks and shares, as well as bonds and other kinds of investments. Returns within this kind of ISA will be more unpredictable and risky over the short term, but give investors the opportunity to receive higher returns.

The maximum that you can put into an ISA for the 2012-2013 tax year is £11,280. In the 2013-2014 year, you can put in up to £11,520. (Each tax year runs from April 6th until April 5th of the following calendar year.)

A key thing to remember is that an ISA is just a tax-efficient wrapper, you still need to make choices about how you manage your money inside that wrapper.

(*Note, that ISAs are not completely tax immune. Dividends generated from equity, both inside and outside an ISA, will automatically have a 10% tax skimmed off the top by the government. If you're a higher rate taxpayer you would normally pay tax on dividend income at 32.5% or 42.5%, but inside an ISA you only have to pay 10%. This 10% tax only applies to equity dividends. It does not apply to income paid by corporate bonds or gilts within ISAs.)

Who Can Invest in an ISA?
UK residents can invest in ISAs. UK citizens living abroad can continue to hold and receive tax relief on existing ISAs but cannot make new investments whilst living abroad. Crown employees who are serving overseas are an exception to this rule: they and their spouses may continue investing in their ISAs as per usual.

Why Should I Have an ISA?
If you are saving for a specific near-term goal, such as a new car or deposit to buy a house, cash ISAs are a helpful tax-efficient savings tool that ensure you can make a bit of money each year to pay for what you want. Even if you’re only putting a small amount into a cash ISA, the rates you receive within an ISA will likely be much better than any rates you would receive outside an ISA.

For longer-term goals, such as saving for retirement, you could invest in stocks and bonds. This is riskier, because you could lose some money in the short-term if your investments do not perform well. However, in the long term, this option gives you the potential to make higher returns than cash. The longer your time horizon, the more risk you can afford to take, which is why someone in their thirties planning to retire at 68 might want to create an investment portfolio that is heavily weighted towards equities.

Yvonne Goodwin, managing director and independent financial advisor at Yvonne Goodwin Wealth Management, currently helps one couple manage an ISA portfolio of £520,000 that is generating roughly £28,000 in tax-free income every year. They don’t have to declare this income at all because it’s generated inside an ISA, says Goodwin. This proves that a disciplined approach to ISA investing can—literally—pay huge dividends in the future. (Note: Income within an ISA can either be reinvested, or funnelled straight into a personal account for immediate use.)

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Alanna Petroff

Alanna Petroff  is a financial journalist with Morningstar UK.

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