Saving and Investing Tax-free in the UK – What is an ISA [Clear Finances]

For those living in the UK, one of the best ways to save and invest their money is to use an ISA (Individual Savings Accounts) where our returns will always be tax-free. We analyze what an ISA is in the UK, and how they work.

What is an ISA in the UK?

Individual Savings and Investment accounts, commonly known simply as ISA, are accounts that make it possible to save and invest in the UK without having to pay any tax in the future. There are several types of ISAs, and it is possible to use a combination of them.

Any realized capital return or income generated within an ISA is tax-free. Regardless of our income level or net worth. And we can decide if we keep those profits in the ISA to be reinvested or take them out to fund whatever projects we may have.

As a result, leaving aside pension plans, which can also be favorable from a tax perspective but lock away our money until we are 55, ISAs are the best tool to save and invest our money if we live in the United Kingdom.

How does an ISA work?

ISA accounts work just like any other savings or investment account. Most banks and financial institutions in the United Kingdom offer them, so it is easy to find an ISA that works for you. In addition, there are comparison websites that will tell you about the best ISAs on the market. A good source for that is Money Saving Expert.

Due to the tax advantages ISAs offer us, the amount we can put into these accounts is limited to £20,000 (about $24,000/€23,000) per year per person. We do not have to put the entire figure in a single ISA, but the combined amount we can invest across all our ISAs will be limited to £20,000 per fiscal year.

Such amount is considerably high for low- and middle-income individuals in the United Kingdom, so it is a real incentive for them to save and invest. In fact, it makes sense to try and max out our contributions every year.

One of the best things about putting our money in an ISA is that we can make withdrawals at any time. Therefore, liquidity will never be an issue.

Types of ISA in the UK

There are a total of 6 types of ISA account in the United Kingdom:

1) Cash ISA

Cash ISAs are the simplest accounts of all. They are a savings account where the interest income we receive will be tax-free.

The maximum annual contribution we make to a Cash ISA is £20,000, as long as we have not invested anything else in other ISAs we may hold.

Cash ISAs tend to offer fixed interest rates for a period of time, like 12 months, 3 years or even longer. Interest rates in 2023 are quite attractive, with many options in the 4-5% range.

Outside of an ISA, tax residents in the UK with an income of less than £50,000 a year can receive £1,000 in interest income without having to pay taxes. Those earning between £50,000 and £150,000 can receive only £500 in tax-free interest. Those who earn more than £150,000 will have to pay tax on all their interest income.

2) Stocks & Shares ISA

ISA Stocks & Shares are the most interesting accounts to save and invest for the long term in the UK. They work like any other investment or brokerage account, and most financial institutions offer them.

Stocks & Shares ISA allow us to invest in all types of financial assets: stocks, bonds, mutual funds, ETF, precious metals ETF, etc.

When choosing a Stocks & Shares ISA it is important to look at the assets available to invest and the commissions we will have to pay. Accounts with lower commissions typically have fewer investment options. Those with greater variety tend to have somewhat higher commissions, but they are always moderate.

With a Stocks & Shares ISA we will be able to collect interest income and dividends, as well as realize capital gains without having to pay tax. This allows our money to work more efficiently and grow faster.

3) Help to Buy ISA

The Help to Buy ISA is a type of ISA that is no longer available to new clients. However, those who have one can continue to use it and make contributions.

It was introduced several years ago to help people purchase a home. It makes it possible to contribute £200 every month and, once we buy a property, the government will pay us a bonus of 25% on all the money we have in the Help to Buy ISA, including the interest we have collected.

The maximum bonus we will receive is £3,000, which means the bonus is capped for balances above £12,000. Nonetheless, it is a good tool to finance our purchase.

The requirements to receive this bonus are that we must be buying our first home, we need to be using a mortgage to finance part of the purchase, and the property price cannot exceed £450,000.

Given we can only contribute £2,400 to a Help to Buy ISA in a fiscal year, we would still have an unused allowance of £17,600 to fund other types of ISA.

4) Lifetime ISA

When the Help to Buy ISA disappeared for new customers a few years back, the Lifetime ISA was introduced. In many respects, the Lifetime ISA is better. The purpose of the Lifetime ISA is to help people with either the purchase of a home or their retirement.

The Lifetime ISA allows us to contribute a maximum of £4,000 annually (the limit is annual, not monthly like in the Help to Buy ISA) and, as soon as we deposit that money, the government will contribute the equivalent of 25% of that.

This means we can receive up to £1,000 from the government every year. Contributions can only be made until we ate 50 years old.

As you can see, for couples looking to buy a home, the combined bonus can be very significant. Two people contributing for 7 years could translate into a combined bonus of £14,000.

Money from the Lifetime ISA can be used to finance our first home, or freely withdrawn if we are over 60.

If we are buying a home, the purchase price cannot exceed £450,000, and we must be financing part of the purchase with a mortgage.

If we want to make a withdrawal without buying a home or are 60 years old, that is possible but comes at a cost. Any money we withdraw will be subject to a 20% tax. Consequently, if we withdrew £5,000, the government would keep £1,000 as a penalty.

One important thing to bear in mind is that, if we are planning to use a Lifetime ISA to finance the purchase of our first home, the account must have been open for at least 12 months prior to the transaction.

5) Innovative Finance ISA

The Innovative Finance ISA was introduced a few years ago. It is designed to make it possible for individuals to use their ISA capital to fund P2P (peer-to-peer) loans.

We can contribute a maximum of £20,000 annually to this type of ISA, as long as we have not contributed anything to other ISAs we may hold.

6) Junior ISA (for children)

The Junior ISA is an account that can be opened for our children. Because a Junior ISA is under our children’s name, the contributions we make do not eat into our allowance.

In order to make contributions to a Junior ISA, both we and our children must reside in the UK, though the are exemptions for government employees abroad. Children must be below 18.

The maximum amount we can contribute to a Junior ISA is £9,000 per child per year. The money can be invested in financial assets, including funds and ETFs, or saved at a fixed rate of interest, with rates that are usually higher than average.

By the time the children turn 18, the money accumulated can be withdrawn by our children without having to pay any type of tax.

Rules and Useful Information about ISAs

Let us discuss some important information that we must consider if we want to take advantage of ISA accounts to save and invest our money in the UK:

We can only hold one account of each type

There are 5 different types of ISA accounts for adults. While we can hold multiple ISA accounts at the same time, we cannot have two of the same type.

This means that, for example, we can have one Stocks & Shares ISA, one Lifetime ISA and one Cash ISA, but we cannot have two Stocks & Shares ISAs at the same time.

Transfer money between ISAs

Money can be transferred freely between our ISA accounts. For example, if we want to transfer funds from a Cash ISA to a Stocks & Shares ISA, we can do it.

Or if we want to move our money from one Stocks & Shares ISA to a new Stocks & Shares ISA, we can do it as long as we close the old Stocks & Shares ISA. This is because we cannot have two ISAs of the same type at any given time.

In most cases, if we want to transfer money from one ISA to another, we must notify our new bank and they will do it on our behalf.

Maximum Annual Contributions

As we have discussed throughout this post, ISA contributions are capped at £20,000 per fiscal year. The caps for Help to Buy ISA and Lifetime ISA accounts are lower, at £200 per month and £4,000 per year, respectively.

The contributions to Junior ISA accounts are capped at £9,000 per fiscal year.

Fiscal Calendar

Finally, it is worth highlighting that annual contribution limits are set for every fiscal year. The fiscal year in the UK starts in early April. Consequently, we could invest £20,000 in March and another £20,000 in April, if the new fiscal year has already begun.

It is worth maxing out our contributions every year since it is not possible to carry over an unused allowance to the following year.

Conclusion

As you can see, ISA accounts are a great tool for saving and investing money in the UK.

If you want to buy a home, an ISA can make it a bit easier. And if you want to invest for the long term, whether it is for income or growth, Stocks & Shares ISA are a must to consider.

I conclude this post by sharing the official link to the British government’s website about ISA accounts.

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