Why you need an ISA
It's bitterly ironic that, just as many of us have decided we need to start saving more, the rates we can earn on our rainy day funds have plummeted.
Britain's descent into recession has made many of us realise the importance of building a nest egg – but if you start a cash stash now, it's likely to grow at a glacial pace thanks to the Bank of England's base rate cuts.
However, investing in an ISA is one way to maximise the money you put by. Here's a simple guide to how they work, and which accounts offer the best deals.
What is an ISA?
ISA stands for Individual Savings Account. As a UK resident, you can save up to £7,200 a year in ISAs and pay no tax on the income you receive from your investment.
ISAs act as protective ‘wrappers' that prevent the tax man from claiming a chunk of the money you put by, whether it is held in cash or stocks and shares.
Thus, there are two types of ISA – cash ISAs and stocks and shares ISAs.
Here's how they work.
Cash ISAs
Cash ISAs work in much the same way as ordinary savings accounts. The key difference is that you receive 100% of the interest earned on your cash.
This could make a huge difference to how quickly your savings pot will grow. Basic rate tax payers usually lose 20% of the interest they earn on savings, while higher rate tax payers kiss goodbye to a whopping 40% of the money they make on their deposits.
In my view, ISAs are now more appealing than ever. According to a recent study by Sainsbury's Finance, less than 4% of the savings accounts currently available pay 3% AER or more on balances – but there are several cash ISAs on the market offering at least this rate.
It makes good sense to save as much as possible in an ISA before opting for any other kind of savings deal.
Anyone aged 16 or above can save up to £3,600 a year in a cash ISA, but you can only pay into one cash ISA per year with a single financial institution. (The remaining £3,600 of your ISA allowance can be saved in a stocks and shares ISA, which I'll explain below.)
Some ISA providers will allow you to transfer savings from previous financial years into your new 2009/2010 cash ISA. These savings will remain tax free and will not count towards your annual ISA allowance of £7,200.
However, you must ensure any ISA transfers you make are handled by the financial institutions involved. If you simply withdraw your money yourself it will lose its special tax free status and you won't be able to reinvest it.
Finally, although many ISA providers will offer you easy access to the cash you save, it's important to remember that once you withdraw money from your cash ISA you cannot reinvest it in the account. For example:
• Catherine saves the maximum £3,600 in her cash ISA at the start of the financial year 2009/2010 (this begins on 5 April). After six months, she withdraws £1,000 to buy a second hand car.
• Later in the year, Catherine wants to put another £1,000 into her cash ISA. However, this is not allowed because she has already invested the maximum amount permissible for the financial year 2009/2010.
My favourite cash ISAs
Right now, there's a wide range of cash ISAs available – some of which offer very attractive interest rates. Here are my top picks:
| Cash ISA | Interest rate (AER) | Minimum deposit required | Are transfers in allowed? | Rules on withdrawals | Extra information |
| Barclays Bank Golden ISA | 3.61% variable | £1 | No | No restrictions | Open to new and existing Barclays customers. New customers must apply in branch. Rate includes a 1% bonus that will last 12 months. |
| NatWest / Royal Bank of Scotland (RBS) Cash ISA Plus | 3.51% variable | £1 | No | No restrictions | Only open to existing NatWest / RBS customers. |
| Halifax ISA Direct Reward | 3% fixed | £1,000 | Yes | Up to four withdrawals of £10 or more allowed each year | If your balance falls below £1,000 or you make more than four withdrawals, the interest rate on your account will revert to the Halifax ISA Saver Direct variable interest rate. |
As you can see, the market's top payers are Barclays and NatWest/RBS. Both accounts offer savers easy access to their cash.
However, it's crucial to remember that the interest rates on both of these cash ISAs are variable – and this means the return you receive on your money could decrease after you open your account.
It's also worth noting that neither account will allow you to transfer in your ISA savings from previous financial years. However, NatWest does offer an alternative ISA, the e-ISA, which allows transfers in. This account comes with tiered interest rates, offering 3.51% AER on balances of £10,000 or more and 3.25% AER on balances of up to £9,999.
Alternatively, Halifax's ISA offers an interest rate of 3% AER fixed for 12 months. This interest rate guarantee is certainly appealing at a time when rates are generally low; however, you will need £1,000 to open this account and withdrawals are limited to four per year.
Unlike Barclays and NatWest/RBS, Halifax allows free transfers in to its cash ISA. This means you can ask Halifax to shift old ISA savings into this account at no cost.
Stocks and shares ISAs
Stocks and shares ISAs are available to UK residents over the age of 18, and you can save up to £7,200 per year in an ISA of this type.
This means that, if you choose to do so, you can invest your full ISA allowance in a stocks and shares ISA. Alternatively, you can place any amount up to £3,600 in a cash ISA and the remainder of your allowance in stocks and shares.
A stocks and shares ISA allows you to invest in individual stocks and shares or investment funds, and has several advantages. Any profits you make from increases in the share price of your investments will not be subject to capital gains tax. Furthermore, while basic rate taxpayers are expected to pay the usual tax of 10% on any dividend income they receive from a stocks and shares ISA, higher rate taxpayers avoid the additional 22.5% tax they would normally be charged on dividend earnings.
The stock market has been very volatile over the past year or so. This has led some financial commentators to suggest shares could now represent good value for money – and that in an era of rock-bottom savings rates, ISAs of this kind might seem unusually appealing.
However, it is crucial to remember that while shares are traditionally viewed as likely to offer better returns than cash in the long term, their value can go down as well as up. There is no guarantee you won't lose your money if you invest it in the stock market*.
If you're thinking of investing in a stocks and shares ISA, you should consider tying your money up for a longer period of time (perhaps five to ten years). It's also a good idea to seek independent advice; the BeatThatQuote.com investments service could help you choose the right advisor for you.
Finally, it's worth being aware that you can transfer your cash ISA savings into a stocks and shares ISA at any point during the tax year, as long as the transfer is handled by the financial institutions involved and you transfer the full amount you have saved.
However, you can't move money from a stocks and shares ISA into a cash ISA once it has been invested – so ensure that you think carefully before deciding how much of your ISA allowance you want to place in each type of account.
* Remember, past performance is not a guide to future returns. The value of investments and the income from them can go down as well as up.
**This material is for information purposes only and should not be considered financial advice. We strongly encourage our readers not to rely solely on this content, but to seek independent advice when making financial decisions.**
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