How ISAs work

An ISA (Individual Savings Allowance) is a simple vehicle for savings and investment.  Their tax-effective structure means that they are often high on the list of recommendations when people request financial advice.

What exactly is an ISA

An ISA allows any adult to save up to £11,280 per year out of their post-tax income without being liable for any tax payable on the income from their investment.  Up to a maximum of £5,640 of these savings can be held in cash.  The rest must be held in stocks and shares.  In 2010 it was agreed that in future years the amount which could be held in an ISA would increase in line with inflation, rounded up to the nearest £120 (for the convenience of those saving out of their monthly salaries).  This means that after April 6th 2013, the limits will be increased to a total of £11,520 per year of which £5,760 can be in cash.

How to save without paying tax

Financial advisers often recommend ISAs because the income generated from them is exempt from further taxation.  The one exception to this is that interest on cash held in a stocks and shares ISA is liable to a 20% charge.  This is essentially to encourage people to invest their money an stocks and shares rather than treating this part of their ISA as an extension of their savings account.  It should be noted that it is entirely possible for there to be a significant difference between the interest rates offered on the the cash component of an ISA and the interest rates offered on cash deposits in the stocks and shares component of an ISA.

What goes in ISAs?

The cash component of an ISA works in essentially the same way as a standard savings account with the exception that if a saver makes a withdrawal, the money can not be replaced later.  The reason for this is that ISA limits are the total limits of all money which can be paid in during the year.  So if, for example, a saver pays in £5,640 and then withdraws £2,000, paying it back would result in a total of £7,640 being paid in over the year, which is above the limit.

For stocks and shares component must contain one or more of a range of qualifying investments, which include: unit trusts, investment trusts, individual shares and various bonds.  Financial advisers will be able to advise on the best options for your particular situation.

Use your full ISA allowance and your spouse’s

Although individuals can choose how much to set aside for their ISA, most people aim to take advantage of their full allowance.  As it is an individual allowance, couples can have one ISA each, meaning that they can save a total of £22,560 per year of which £11,280 can be in cash.  Since the two ISAs will be separate, couples can choose whether to have a mixture of cash and investments in both or to keep one purely for investments.  There are also junior ISAs, which have slightly different rules.

How to switch ISAs

ISA transfers must be carried out between ISA providers.  If an individual withdraws cash (or liquidates investments) themselves this will be treated as a standard withdrawal and paying the money into another ISA will only be permitted if the amount is below the annual investment limit.