Six types of ISA: how to make the most of your tax-free savings
An ISA is simply a tax wrapper, a way to save money tax-free. ISAs used to be very simple, as were their predecessors, PEPs and TESSAs. Nowadays they’ve become increasingly complex, so it’s worth taking a little time to find out which is the right ISA for you – there are six main types on the market, so plenty of choice depending on where you are in life.
The tax year-end is approaching (5 April), so make sure you allow enough time to open an account and transfer your money – do it sooner rather than later!
The most common of the options, this is a deposit-based ISA that acts like a bank account for your savings, where interest is tax-free. Anyone aged 16 years or over can save up to £20,000 annually.
A couple of challenges to bear in mind:
- Since the introduction of the personal savings allowance – an annual allowance of tax-free interest an individual can accrue in any of their accounts, which is £1,000 for basic rate taxpayers and £500 for higher rate taxpayers (nil for additional rate taxpayers) – cash ISAs aren’t quite as attractive as they used to be. Interest of £1,000 at the current interest rates would require saving at least £50,000! So the cash ISA doesn’t really give you an advantage there.
- The RPI measure of inflation hit 4% recently. There are no cash ISAs I’m aware of that return 4%, so in real terms you’re losing money with a cash ISA.
That said, step 3 of The Money Plan involves saving 3-12 months of your expenses as an emergency reserve, and a cash ISA can be a great place to save that. But don’t be swayed by a cash ISA over a higher interest rate available on a savings account, because of the personal savings allowance mentioned above – take the highest interest rate you can find, regardless of the account.
Stocks and Shares ISA, AKA Investment ISA
These have become a lot more popular in recent years. There’s a £20,000 limit, and this shelters money from capital gains tax and income tax, which explains the increased popularity – especially for those who have reached their annual or lifetime pension allowance.
You can buy anything from direct shares in individual listed companies to collective funds, unit trusts and investment trusts– what you can invest in is very broad, and you can focus on the UK and overseas as well.
How to choose the right one? I like a quote from a jewellery company in America that says, “If you don’t know jewellery, know the jeweller.” Investing is the same: if you don’t know investing, at least trust the company providing the investment platform. You need to go with someone who has a good reputation, and I’d suggest you go with a passive arrangement which will keep your fees lower than an active fund will.
I looked at the market five years ago and I couldn’t find an online platform that I’d be willing to put my own money into for an ISA – so I created one, Lexo.co.uk. This is an online investment platform that lets you invest in a passive arrangement that I’ve put together myself. Lexo offers 10 risk-rated portfolios to choose from and you can do it all online at the click of a button. We make no initial charge and there are no time period limitations. It’s a great platform, fully automated and is backed by us here at Lexington Wealth.
One final thought – to invest in a stocks and shares ISA, you should be thinking long-term, as you should for any stock market investment. The market’s been going up for a long time now, but that period will end and it will come down, then recover again. I always say you need to plan for at least 5 years, preferably 7 years, to keep your money in any stock market investment. If you’re looking to buy a house in three years, use a cash ISA not a stocks and shares ISA; if you’re investing for your children’s education in 10 years, or to top up your retirement income, then stocks and shares is the way to go.
An ISA specifically designed for children. This allows parents, godparents, friends or even the child themselves to save money in a tax-free environment, in the name of the child. The savings limit for a Junior ISA is £4,128 annually, which typically goes up each year.
One of the benefits is that it educates the child in disciplined financial savings at a young age. It’s our habits that make us and our habits that break us, so if you’re teaching good habits at a young age they’ll hopefully take those through to adulthood.
There’s no access to the money until the child is 18 at which point the money reverts to the child’s name in a stocks and shares ISA which is instantly accessible by them.
I like Junior ISAs, even if you’re only saving modest amounts of money, because it engages children in the education of saving and investing – regardless of your own practices as an adult.
A final note – children born between September 2002 and January 2011 (7 to 16 years old) may have the predecessor to the Junior ISA in their name, the Child Trust Fund. They were similar, but more restrictive and offered by fewer providers. A Child Trust Fund can be transferred over to a Junior ISA very easily, and should be considered.
Lifetime ISA (LISA)
This is a fantastic option for anyone aged 18 to 40 years old. It’s a brilliant ISA where you can fund up to £4,000 annually, up to the age of 50 once you’ve started the LISA, plus you get a 25% bonus from the government each year (initially paid at the end of this tax year, and then ongoing on a monthly basis).
The catch? The money that you save must go towards one of two things: the purchase of your main home, up to the value of £450,000; or your retirement, from age 60 onwards.
This is the first time this kind of criteria and the two-pronged approach has been introduced to ISAs. Many in the financial planning industry believe this is the way ISAs and maybe pensions will go in the future.
It’s more complex but it’s a fantastic ISA. I’ve done some number crunching and if you took out a LISA aged 18 and fully funded the £4,000 every year until you turn 50, you’ll receive £32,000 in government bonuses – free money.
And remember in addition to that, the money you save is invested in the markets, so you’ll benefit from that growth too. It’s reasonable to assume your money will double every 10 years (approximately 7% return), so there’s good money to be made from taking out a LISA.
I believe that if you’re young, don’t own a home yet but plan to in the future (five years or more from now), your first £4,000 of savings every year should be put into a LISA. If you’re buying a property with somebody else they can also take out a LISA, doubling your combined money.
And if you have a fully funded stocks and shares ISA from previous years but don’t think you’ll be able to save £4,000 in the next tax year for a LISA, simply consider transferring £4,000 from your stocks and shares or cash ISA into your LISA at the start of every tax year to maximise your 25% government bonus.
Help to Buy ISA
This is basically the LISA’s predecessor, offered by banks and building societies to encourage people onto the property ladder. Help to Buy ISAs have a limited shelf-life now – new accounts will only be available to be opened until November 2019.
This is more of a deposit-based ISA (like the cash ISA), and it does give you bonuses but the amounts you can save in them are capped: £1,200 to open the ISA, and £200 per month thereafter.
There are also stricter limits on the price of the house you can buy – outside London it’s £250,000, in London it’s £450,000 (like the LISA).
I don’t think that there are any reasons why you’d choose this over a LISA nowadays, the latter offers better bonuses and higher limits nationwide.
Launched to encourage innovative investment options, these ISAs are mainly used for peer-to-peer lending. If you put for example £1,000 into such platforms, they’ll break that up into e.g. £25 chunks and lend it out to 40 different borrowers. This ensures diversification, so that if a borrower goes bust, you only lose a small amount of your money.
The important thing to remember here is that Innovation ISAs are not covered by the Financial Services Compensation Scheme, so if the lending platform goes into default you could lose all of your money.
They’re paying quite nice returns, but the peer-to-peer lending platforms themselves are warning that as more and more borrowers use them, default rates for those companies are likely to increase over time; also if the economic climate worsens, default rates may follow.
The limit is £20,000 annually, and I’d suggest you should only invest anything like that amount if you have a very significant amount of capital saved, because of the risks outlined above. The returns can be worth it, but remember those risks and consider them carefully before investing.
So which ISA is right for you?
As you can see, there are a great range of options for your ISAs, from new ideas to children to the more well-known examples. All offer tax-free returns, but the right one for you depends on your circumstances. If you’re looking to save for a child or for a home in the future, be sure to check out LISAs and Junior ISAs.
A note on allowances. The JISA is an allowance offered to your child, albeit anyone can fund the JISA on their behalf. For adults there is a £20,000 total allowance, which covers all other ISA contributions you make (Cash, Stocks & Shares, Help to Buy and LISA). So if you invest £5,000 into a cash ISA, £4,000 into a LISA, you will have £11,000 remaining for a Stocks & Shares ISA.
At Lexo we offer Stocks and Shares ISAs, Lifetime ISAs and, if you have enough capital, we’ll offer a Junior ISA as well. It comes as no surprise I’m sure that I’d strongly recommend Lexo for your ISA requirements! But the ability to manage everything online from a trusted provider does make it a very good platform, whatever your approach to risk vs reward.