what is ISA and how to benefit from it

Today I want to cover the very basics of what is an ISA. A topic that I believe every single one of us looking to improve their long term financial situation should be aware of. In my view it is one of the best thing the government gives people looking to invest. At the same time – there is a lot of confusion and lack of knowledge around these. Both things combined lead to public not benefiting from ISAs at all.

what is ISA

I will start with the very basics – what does ISA actually mean? ISA is a short for Individual Savings Account. I will add slight confusion into the mix next. There is more than one type of ISAs you can actually opt to open and hold. I will go into detail of different options available shortly and explain the key types and differences there are. 

You will probably have few questions on your mind by now. Why do I need an ISA? How is it different from any other type of investment I can make? The answer to these is very simple. The benefit of ISAs is simple and really straightforward – ALL ISAs ARE TAX FREE!!! Yes, this wasn’t a typo – all the gains you make through any of your ISAs do not require you to pay any tax.

If you use an ordinary investment account you might be required to pay tax. There are limits to how much you can earn from your investments in the UK before taxman will knock on your door. This will very much depend on your personal circumstance – your salary, other income from business/being self employed, property, etc. All of the above are eating into your personal allowance and in no time you will see yourself being required to pay your tax bill. To avoid the above headache simply use an ISA as your investment tool.

who can benefit from these and when to use it

ISA is available to any UK resident or person serving abroad for the Crown. You can open Cash ISA as early as 16 years of age. More complex ISAs have an age limit of 18 years. There are no other requirements or limits to open an ISA account. Your kids under the age of 16 can also have an ISA. I will go into more details of available options and their benefits below.

As with everything there is a little BUT when it comes to ISAs. There is an annual allowance that each individual gets. ISAs have currently got a limit of £20,000 per financial year (this is accurate for 2022/23 financial year). This amount should be sufficient for most to get the maximum benefit out of this TAX FREE wrapper.

One of the points that many people get confused with when it comes to ISAs is around the £20,000 annual allowance. Some think, and I have to admit that I was the same when I first learned about ISAs, that the allowance you get is the maximum value of the ISA accounts you can hold in order to benefit from these being TAX FREE. 

The truth however is different. Your annual allowance is what you can top up your existing ISA balance by. I will give you an example. I will assume that the ISA allowance won’t change the next financial year. If you were to max out your ISA this year and reach that £20,000 then next financial year you could add a further £20,000 into it. This would make the total ISA value you are holding £40,000 by the end of next financial year less any gains or losses from your investments. I need to make you aware at this stage – any investments you make are always at risk of your value going both up or down. So please, only invest what you can afford to lose.

In the paragraph above I said – “I will assume that the ISA allowance won’t change”. The government can review and increase or decrease this figure as they see fit. I don’t think that the allowance has actually ever decreased from one year to another. The increases on the other hand are something that has happened previously. It was 2010 when I first learned about ISAs. The annual limit was standing at £10,200 back then. On top of that, only half of that could be held in cash ISA. The good old days when cash ISAs actually payed good interest.

The very short summary of the above is as follows. Every person who is considering to start investing should start with an ISA account. The only exception in my personal view would be the case when the amount you are looking to invest is way more than £20,000. I can understand some would opt for the simplicity of managing the investments in one account. However, that should only be the case when the investments are significantly above the tax free allowance. The opportunity cost of making life simple can also be of significant value to you.

different types of isas available

I will cover the basic level on what are the different types of ISAs available for you to use and benefit from. I will not go into too much detail on these in this article. Instead, I will write a separate post on what my personal views are on the best ISA to use. I will cover benefits they give as well as risks associated with these.

CASH ISA – as name suggests, this ISA allows you to hold your savings in cash. You can benefit from interest that your chosen provider is willing to pay you. A big watch out here is to compare the interest rate that you are getting with the inflation rate. If the interest you are earning is below the inflation rate than in real terms – your investment is loosing you buying power. You can learn more about what is inflation over here.

STOCKS AND SHARES ISA – these accounts are also known as investment ISAs. As the name suggest – these allow you to move your savings into different types of investments. Shares often offer a higher potential for value appreciation. The flip side to higher returns is the increased risks you have to take. Before you do any further research to learn if investment ISA is right for you keep the following in mind. My biggest advice is not to put all your money into only one company. Decision like that can wipe your entire portfolio out in no time. Diversification is the key with buying into stocks.

INNOVATIVE FINANCE ISA – these ISAs are a bit more complex. These ISAs allow you to lend money to others. This is also called peer-to-peer lending. One of the benefits of this is the fact you cut the banks out of the equation. This means you can potentially get higher returns than in cash ISA. By doing so you are also increasing the risk you are taking. Your investment is only as safe as the person you choose to invest into. You need to be sure the person is knowledgable of what they do with your cash.

LIFETIME ISA – also known as LISA. LISA is there to help people to get on the property ladder or to help them when they get older. These have a limit of £4,000 per annum that comes out of your total ISA allowance of £20,000. The benefit to these is that government puts an additional 25% on top of the value you invest. In simple terms – for every £4,000 you put in the government adds £1,000 to it. These can be used to fund your first home or to use when you get to the age of 60. There are watch outs with these. If you withdraw money out for any other reason the 25% bonus will be taken away. You will potentially be liable to pay additional charges as a result. An option to consider however you need to do further research if the conditions of LISA work for you.

JUNIOR ISA – the last option I will mention here. This is the option that allows parents to open an ISA for their kids below the age of 16. You can enjoy additional £9,000 tax free on top of your personal allowance through this ISA. The owner of the ISA however is the child. The parent or the guardian is only the to manage the account. The child can start managing the account at the age of 16. She or he however can’t withdrawn cash up to the age of 18.

These are the ISA options available in the UK. You should have a very top line summary of these now. I will go into more detail on these in further posts. The articles will cover the key benefits of each but also focus on the risks each one of them has. I hope you found this article useful. While ISAs can sound complicated – they are actually not. This article gives you some food for thought on how to start benefiting from these.