What is an ISA account?

The Individual Savings Account (ISA) a UK-based investment or savings account exempt from income and capital gains tax up to a certain annual allowance limit. Here we take a look at ISA account definition in more detail.

Key points

What is ISA account?

So, what does an ISA account mean? The Individual Savings Account allows UK residents to save and invest in a tax-efficient way. All major banks and building societies provide ISAs. It’s important to note that certain types of ISAs still require holders to pay tax, but at a lower rate.

ISAs have a limit on how much money can be saved in each tax year. The UK government sets the annual ISA allowance each year and holders are taxed on the returns within the allowance. The ISA allowance for the 2022/2023 (6 April to 5 April) tax year was set at £20,000. 

In contrast, ordinary savings accounts have no savings limit. Holders can save any amount of money in their ordinary savings accounts, but the interest earned will be taxed.

Different types of ISA accounts explained

There are various ISA account types. Each has specific guidelines, which may include limitations on deposits and withdrawals of funds. 

The maximum amount that can be deposited varies from year to year, but has been steadily increasing since the account's introduction. Let’s examine ISA account examples in more detail. 

Cash ISA

A cash ISA is similar to an ordinary savings account, with the exception that the holders do not pay income tax on the interest earned. 

A cash ISA may offer variable and fixed interest rates. Fixed rate cash ISA typically offer higher yields than the variable rate, yet with the condition that holders cannot withdraw their money out before the fixed term ends, or they must pay a penalty for early withdrawal.

On the contrary, variable rate Cash ISA gives the flexibility to holders to withdraw their money, but it carries a lower interest rate. 

Stocks and Shares ISA

This type of ISA account is typically offered by UK stock brokers and is considered a tax-efficient way of investing for the UK residents. 

The money deposited into a Stocks and Shares ISA is used to buy company shares and other types of investments. The profits earned in the ISA account are exempt from capital gains and income tax, provided the deposit was within the yearly allowance.

Innovative Finance ISA

This type of ISA allows holders to use the annual ISA allowance to lend the funds to other borrowers via peer-to-peer lending market. The interest earned on the lending is tax-free.

This type of ISA account is designed to pair up individuals and businesses in need of cash with investors and lenders who are willing to provide it for interest. 

Lifetime ISA

The Lifetime ISA (LISA) allows holders to efficiently save for the purchase of their first home or retirement.  Applicants must be at least 18 years old and under 40 to open a LISA.

Before turning 40, holders must make the account's first deposit. They can save up to £4,000 a year until turning 50. The savings will earn a 25% bonus from the UK government, up to a maximum of £1,000 annually.

There are two types of LISAs: Cash LISA and Stocks and Shares LISA. While the first one involves simply saving cash, the second one allows holders to invest this money for profit in addition to the government bonus. You can only have one LISA account. 

The Lifetime ISA must be used towards the purchase of a first home with a mortgage or retirement. The first home must have a price of £450,000 or less, be in the UK and the only home you own, as well as the place where you intend to live, rather than rent out.

You can also withdraw your LISA savings after you turn 60 and use it to fund retirement. The withdrawal before 60 for any other purpose than buying a home is discouraged, incurring a penalty of 25% on the entire money pot.

Junior ISA

As the name suggests, a Junior ISA is designed to be a long-term tax-free savings or investment for children under 18 years old. 

To be eligible to open a Junior ISA, the holders’ children must be living in the UK. Children living outside the UK can have a Junior ISA if their parents serve in the UK’s armed forces, diplomatic service or are civil servants assigned overseas.

Similarly to LISA, there are two types of Junior ISAs: Cash ISA, and a Stocks and Shares ISA. Parents can open one or both types of Junior ISAs.

How does an ISA account work?

Holders can save or invest up to £20,000 in one type of ISA account or spread it across other types during the tax year. For example, a holder can save £10,000 in a Cash ISA, £6,000 in a Stocks and Shares ISA and £4,000 in a Lifetime ISA. 

Holders can keep their savings after the tax year ends as long as they keep the money in their ISA accounts. They can also transfer funds from a previous investment or cash ISA into a new one, still staying eligible for the£20,000 tax-free allowance for the current tax year. 

To open an ISA, applicants must be a UK resident over the age of 16 for a Cash ISA account and over 18 for a Stocks and Shares or Innovative finance ISA. Junior ISAs are available for children under the age of 18.

Holders can open ISA accounts at various financial institutions, including banks, credit unions, stockbrokers, building societies and peer-to-peer lending societies. 

Pros and cons of ISA accounts

The main advantages of ISAs are the tax benefits that allow holders to earn increased returns on their savings and investments. However, there is a risk that the tax regime may change in the future. 

According to financial service firm Hargreaves Lansdown, investing or savings in ISAs could protect holders’ money from future tax. The firm said: 

ISAs, like any other personal finance instruments, have drawbacks. The limit on the tax-free deposit and the penalties for withdrawal for some ISA accounts are the key disadvantages.

The bottom line

ISAs can offer tax-free investment or savings with a wide range of choices to meet holders’ circumstances. However, the cap on annual contributions mean holders may not have the flexibility to grow their money at the desired pace.

Always base your trading or investing decisions on your risk tolerance, market expertise, portfolio size and objectives. Conduct your own research before investing. And never trade money you cannot afford to lose.

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