What is an ISA? UK tax-free savings explained

There are a few different forms of ISA accounts - how do they work? And what do you need to consider before opening one?

What is an ISA? Pros and cons
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If you’re looking to build a savings pot, then an individual savings account (ISA) can be an effective way of doing so.

It’s not easy to squirrel away cash each month given the cost of living crisis. With energy bills rocketing and the price we pay for things like food also on the rise, many people don’t have much disposable cash left over.

As a result, it’s really important to get the best possible return from any money you are able to save.

Here we explain what an ISA is, how different types of ISAs work and how much you can save in it.

What is an ISA account?

An ISA is a type of savings account, which allows account holders to enjoy tax-free returns on their savings. 

Shaun Moore, tax and financial planning expert at Quilter, explains: “Put simply a cash ISA is much the same as a regular savings account however you will not be taxed on any of the interest earned.”

But, there are a few different forms of ISA, which might suit different types of saver. 

  • A cash ISA means that your money is kept in cash, and so it works rather like a regular savings account you might hold with your bank or building society. It means that you will never lose money, though you might not earn a huge return either.
  • A stocks and shares ISA is a type of investment ISA, where you money is invested in the stock market. This has the potential to deliver far greater returns should those investments pay off, but equally if things go poorly then you may end up with less than you initially put into the account. What’s more stocks and shares ISAs may come with additional fees to consider.
  • A lifetime ISA (LISA) is a relatively recent form of ISA designed to aid people looking to save either for retirement or for a deposit, and comes in both cash or stocks and shares forms. Alongside the interest earned from the money you save into a lifetime ISA, you will also get a bonus from the government of 25% of the amount saved (up to £1,000) each year based on how much you save into the account, though this will be wiped out by withdrawal fees if you use the money for some other purpose other than buying a home or for your retirement.
  • An innovative finance ISA (IFISA) which was put together specifically for those looking to invest in peer-to-peer style businesses, where you earn interest by lending your money out to other individuals or businesses. As with a stocks and shares ISA, this form of saving comes with a greater level of risk involved ‒ for example if the borrower is unable the repay their loan ‒ but can potentially deliver higher returns than a regular cash ISA.
  • The Junior ISA, which as the name suggests is a form of ISA for the under 18s. Junior ISAs are available as both cash ISAs or stocks and shares ISAs, with the money within the account going straight to the named child when they reach 18.

 ISA vs savings account - what's the difference? 

The big difference between an ISA and a regular savings account is the way that interest is taxed.

The whole point of using a savings account is to earn some interest on the money you set aside. It means that your balance grows over time, hopefully leaving you better off over the long run than if you had simply stuck the money in a piggy bank under the bed.

However, with a regular savings account the interest you earn may be subject to tax. Basic rate taxpayers benefit from a £1,000 savings allowance, meaning that the first £1,000 you earn in savings each year is tax free. This allowance drops to £500 for higher rate income taxpayers.

Beyond that point, you start paying income tax on the interest earned.

However, money held within an ISA wrapper is different. You enjoy the entirety of any interest paid on an ISA, without the taxman taking a slice.

In the last couple of years, this distinction has become less important. The interest rates paid on savings accounts have been so low that relatively few savers have been able to secure interest payments above that £1,000 or £500 threshold, meaning that ISAs have lost some of their lustre.

This has changed of late, however. Base rate has been increased a handful of times already this year, which has driven up the rates of interest paid on regular cash ISAs. As a result it’s becoming more common for savers, particularly those who pay the higher rate of income tax and therefore who only have a £500 personal savings allowance, to face paying tax on their savings interest.

What is my ISA allowance? 

All adults enjoy an annual ISA allowance, covering how much they can save into their ISAs in any given tax year.

Any unused allowance doesn’t carry over to the next year ‒ you have to use it or lose it, essentially.

The ISA allowance for the 2022/23 tax year stands at £20,000. This can be invested in just a single ISA, or split across different types of ISA ‒ it’s up to you.

The lifetime ISA is subject to a smaller allowance at £4,000 per year, but you can then use the remaining £16,000 ISA allowance elsewhere.

Junior ISAs also have a lower annual allowance. Currently up to £9,000 each year can be saved into a junior ISA.

It’s important to bear in mind that the allowance covers the total you can pay into your ISA or ISAs over the year, irrespective of any withdrawals made. For example, if you pay in £20,000 at the start of the tax year, that is your full allowance accounted for ‒ if you withdraw £10,000, you cannot simply top the balance back up again over the remainder of the tax year.

How many ISAs are you allowed? 

There is no limit on how many ISAs you can hold overall, though there are limits on how many new ISAs you can open in a single tax year.

Each saver can open one of each type of ISA in each tax year. So you can open a stocks and shares ISA and a cash ISA in this tax year, but you cannot open two separate stocks and shares ISAs.

This doesn’t mean that you cannot hold more than one type of cash ISA though. You might have opened one in a previous tax year, but decided to open a new cash ISA in this tax year.

You can then contribute to as many different ISAs as you like within a single tax year. For example, if you hold a cash ISA, a stocks and shares ISA and a lifetime ISA then you can pay into as many or as few of them as you like during the year.

Rachel Springall, personal finance expert at Moneyfacts, says: “Some ISAs sit under Flexible ISA rules and some providers will allow savers to spread their yearly allowance across their ISA range, which is handy for investors who want to use both easy access or fixed cash ISAs. Cash ISAs will likely remain the default choice for many savers, but with interest rates so low and inflation rising, some savers may also wish to explore stocks and shares ISAs.” 

Can you transfer money between ISAs? 

You can transfer money between ISA accounts, but it’s important to do this directly rather than withdraw it from the first account and then pay it into the second. 

As Springall explains: “If savers want to keep their cash protected from tax, then they must ensure they transfer their ISA monies from one to the other and not encash it.”

There are also rules covering how much can be transferred.

Moore says: “One thing to bear in mind is that if you transfer money from the current year’s ISA, you must switch the full amount. For example, if you had £6,000 in an ISA in the current tax year and £2,000 in the previous year. If you want to switch to a different ISA in the current year, you would have to transfer the full £6,000 from this year’s ISA. But you could choose to switch only £1,000 from the previous year.”

It’s also important to remember that not all ISAs accept transfers from older ISA accounts. As a result it’s really important to check if transfers are permitted before opening a new account, should you be a seasoned ISA saver.

John Fitzsimons
Contributing editor

John Fitzsimons has been writing about finance since 2007, and is a former editor of Mortgage Solutions and loveMONEY. Since going freelance in 2016 he has written for publications including The Sunday Times, The Mirror, The Sun, The Daily Mail and Forbes, and is committed to helping readers make more informed decisions about their money.