We explain how ISAs work so that you can make the most out of your tax free savings allowance.
What is an ISA?
An ISA (individual savings account) is an individual allowance that enables you to save up to £7,200 a year (increased from £7,000 on 6th April 2008) free from income and capital gains tax, maximising the interest you earn on your investment. ISAs were introduced as a replacement for PEPs and TESSAs in 1999 and have been guaranteed to run in their current form indefinitely.
(In the 2009 budget the Chancellor announced that the ISA limit is set to increase to a total tax free savings allowance of £10,200, £5,100 of which can be saved as cash. This is set to come into effect later in 2009 for those over 50 and next year for all other savers).
Who can open an ISA
ISA's are available to all UK residents over the age of 16 (although you must be over 18 to invest in a stocks and shares ISA component). Additionally, Crown employees working overseas but paid by the British government (i.e. military personnel or diplomats) are also eligible for an ISA allowance, as are their spouses and families. However, as they are an individual tax allowance, ISAs must be opened and run by a specific individual and cannot be held in joint names or as a trustee account.
How do ISAs work?
ISAs are commonly referred to as 'wrappers', protecting a certain amount of your savings from tax. You can choose to use your ISA allowance to invest in either a cash component, a stocks and shares component, or a combination of the two, potentially accumulating an extra 20% interest on your investment if you're a basic rate tax payer and 40% if you usually pay tax at a higher rate.
The cash component of your ISA allowance enables you to save up to £3,600 each financial year (increasing from £3,000 on 6th April 2008) in a cash-based savings account without having any tax deducted from the interest your savings accumulate. These are generally operated as a regular savings account, allowing you access to your money as and when..
The stocks and shares component of your ISA allowance enables you to invest up to a maximum of £7,200 each financial year in individual stocks and shares or in unit or investment trusts (less any amount invested as cash). When you use this component to invest, any capital growth on your assets will be completely tax free. What's more, you will not be required to pay tax on any dividends you receive.
What's the difference between the different types of ISAs?
Prior to 6th April 2008 there were two different types of ISAs, Maxi and Mini. Mini ISAs were made up of 2 components; a £3,000 cash allowance and a £4,000 stocks and shares allowance, each of which could be taken from a different financial provider. Maxi ISAs were more flexible as while they allowed you to invest up to £3,000 in a cash component, they enable you to invest up to your whole £7,000 allowance in stocks and shares if you so wished.
However, to make ISAs more accessible this distinction has now been scrapped and, as of 6th April 2008, the complicated Mini/Maxi system has been replaced with a far simpler scheme.
Now, each tax year, savers have the flexibility to invest up to £3,600 in a cash ISA and up to £7,200 (less any amount you invest as cash) in a stocks and shares ISA, it’s really as simple as that.
Additionally, from this April date, existing mini cash ISAs, TESSA-only ISAs and the cash compentent of maxi ISAs automatically became ‘Cash ISAs’, while mini stocks and shares ISAs, the stocks and shares components of maxi ISAs and PEPs automatically became ‘Stocks and Shares ISAs’.
What’s more, you are now also able to transfer any funds saved in a cash ISA into a stocks and shares ISA without penalty, under the old scheme this was not possible.
How much can I save?
It is possible to save up to £3,600 each year in a Cash ISA and up to £7,200 in stocks and shares (or whatever allowance you have left) if you do not choose to use your entire cash component.
Your £7,200 ISA allowance runs from the 6th April one year until the 5th April the following year, after which you will be given a new £7,200 allowance. While any money you invest in an ISA during one financial year will uphold its tax free status indefinitely, any unused allowance will not be rolled over. This means that if you don't use your full tax-free ISA allowance, you lose it.
Once you have invested money in an ISA it gains its tax-free status immediately and does not lose this benefit once you decide to withdraw it. However, once you have paid in your full allowance during a tax year you are not able to invest anything further under your ISA 'wrapper', even if you have made withdrawals.
Compare savings accounts via money.co.uk
