How do ISAs work?
Discover tax-free savings with our quick guide to ISAs, including the annual ISA allowance, the pros and cons of different ISA types and finding the right one for you.
Stocks and shares ISAs have the same tax benefits as cash ISAs – all returns are free from UK tax. They also have the same yearly allowance, which is £20,000 for the tax year 2023/24. So which one should you choose?
What’s right for you will depend on your circumstances and appetite for risk. Cash ISAs provide an easy way to earn interest on your money, while stocks and shares ISAs aim to generate more significant growth by investing your money in areas such as the stock market.
Choosing an ISA isn’t always easy, and there’s a lot to consider – as we’ll see below.
Bear in mind that the value of investments can go down as well as up. You could get back less than what you put in.
A cash ISA is perhaps the simplest type of ISA. It allows you to earn tax-free interest on your cash. With a cash ISA, you can usually choose between a variable or fixed interest rate.
A variable rate cash ISA will usually have a lower rate of interest, but will allow you to withdraw money whenever you need to.
A fixed rate ISA may provide you with a slightly higher rate, but you might need to leave your money untouched for a set period of time.
As with all ISAs, there are a number of pros and cons associated with cash options. As well as offering a low-risk way to save, some cash ISAs also allow you instant access to your money, making them well-suited to funding short-term projects.
Due to their low-risk profiles, cash ISAs can also provide an effective way to build rainy-day funds for emergencies – for example, an unexpected bill or sudden loss of earnings. However, low interest rates mean little potential for growth.
The benefits of a cash ISA include:
With a low-interest savings account – such as most cash ISAs – there is a risk that your cash savings may struggle to keep pace with inflation.
In other words, even though your cash balance is steadily increasing, your money may be worth less in real terms as things become more expensive to buy.
For example, in 1980, three loaves of bread would have cost around £1. In 2020, the average price for one loaf of bread was £1. So, £1 can buy you less now than it could in 1980, and in the future, it will buy even less.
You can see the potential impact of inflation on your savings in our handy inflation calculator.
While a cash ISA earns you interest on your savings, a stocks and shares ISA aims to provide greater returns through dividends and capital appreciation (the value of your investment going up). As per ISA rules, any potential gains you make from your investment are protected from UK tax.
Like all investments, though, there’s an element of risk involved. An investment ISA can help your pot grow faster than cash savings, but it does expose you to the risks of the stock market – meaning you may get back less than what you put in.
Bear in mind too that most investment ISAs recommend leaving your funds in place for a minimum of five years, making them best suited for longer term savings. The longer you invest for, the more time your investment has to grow and benefit from compounding (where you’re generating interest on interest that can be reinvested).
The benefits of a stocks and shares ISA include:
If you feel your financial goals would benefit from splitting your money across a cash ISA and a stocks and shares ISA, there’s absolutely no reason why you can’t do both.
You can pay into both types of ISA in the same tax year, as long as your total combined contributions don’t exceed your yearly allowance. You don’t get a separate allowance for each type of account.
If you’re still unsure which type of ISA is right for you, it’s always best to seek professional advice from a Specialist Financial Adviser who can provide expert guidance tailored to you.