How ISAs work: types, benefits and choosing the right one

There’s no time like the present to start saving for your future, even if it’s just a small amount each month. The big question is where to put your hard-earned cash. 

Individual savings accounts (ISAs) are just like other savings accounts, only with the added bonus that the interest you earn is tax-free. 

Here, we explain all you need to know about ISAs, including what’s available, how much you can invest, and which option could be best for you.    

What is an ISA?

The government introduced ISAs in 1999 to encourage people to save. You can open one at 18, provided you’re a UK resident, a member of the armed forces or a Crown servant. Their key selling point is that any money earned in interest is tax-free, unlike the alternatives, including standard savings accounts. This means you don’t pay:

• Income tax on cash ISAs

• Capital gains or income tax on stocks and shares ISAs

How do ISAs work?

An ISA is a ‘tax wrapper’ around a normal savings account or investment that most banks, building societies and investment managers offer. From the start of each tax year on 6 April, you can put up to the current year’s annual allowance into ISAs. It’s up to you whether you put your money into your existing ISAs, new ones or a combination of both. 

Opening an ISA is no different from opening any other account. You also manage them in the same way – for example, via a phone app or online.

What are the different types of ISAs?

These are the main types of ISA to consider if you want to start saving or investing:

Cash ISAs

• Tax-free instant, limited access or fixed-rate savings accounts

• You can usually open a cash ISA with as little as £1

• You can open one or more each year, but you can’t save more than the annual allowance

• You typically need to be 18 to open a cash ISA – the exception being anyone who was 16 or 17 on 5 April 2024

Stocks and shares ISAs

• Stocks and shares ISAs are also known as equity, investment or share dealing ISAs

• They provide a way to invest, tax-free, in a range of investments, including shares, funds and bonds

• You can make lump sum or regular payments each year up to the annual ISA allowance

• You can open one from age 18

• Usually, there’s no charge for taking cash from your ISA (but there may be a charge for selling shares)

• Your investments don’t attract capital gains or income tax

• Capital at risk

Lifetime ISAs

• Account designed for prospective first-time buyers or to save for retirement

• Available to anyone aged 18 to 40

• You can deposit up to £4,000 per year until you’re 50

• The government pays you a 25% bonus if you use money from your ISA to buy your first home, if you’re 60 or over, or if a doctor has informed you that  you have less than 12 months to live

Innovative finance ISAs

• Lets you invest a sum of money in new or expanding businesses

• Offers a fixed amount of interest in return

• Managed via an online portal

• What you get back depends on the loan term

• Similar to peer-to-peer lending but with the added bonus of being tax-free

• You must be 18 to take out an innovative finance ISA 

• Capital at risk

Junior ISAs

• Junior ISAs are designed for children

• They come in two types: cash ISA and stocks and shares ISA

• The account holder for a junior ISA is the child, not the parent or legal guardian who opened the account

• The account holder must be under 18 and live in the UK 

• Parents (or legal guardians with parental responsibility) can open one junior cash ISA or one junior stocks and shares ISA for their child every year. Or they can open one of each

• Young adults aged 16 or 17 can open their own junior ISA, and take control of any opened for them at an earlier age

• The account holder can either withdraw from their ISA at 18 or allow it to become an adult equivalent ISA

• Parents can’t take money from a junior ISA unless the account holder is terminally ill or dies

How much can I put in an ISA? 

There is a cap on how much you can put into an ISA each year. Currently, this is £20,000. The money can be put into a single cash ISA, stocks and shares ISA or an innovative finance ISA. 

You could also add a lifetime ISA to the mix. Lifetime ISAs have a lower limit than the other options, as you’re limited to a maximum of £4,000 a year due to the 25% bonus. 

The annual allowance for a junior ISA is £9,000.

What are the rules for withdrawing money from an ISA?

You can withdraw money from your ISA whenever you want, although there are some rules to consider:

• Cash ISAs: flexible cash ISAs allow you to withdraw and re-deposit your money without this movement affecting your current year’s allowance. However, not all ISAs offer the same benefit. You should check your terms and conditions carefully before making any withdrawals to ensure your savings don’t lose their tax-free status

• Fixed term cash ISA: You may face a fee if you withdraw money held in one of these ISAs - this could be the equivalent of 180 days’ interest, for instance  

• Lifetime ISAs: If you withdraw money from one of these ISAs before you’re 60 – other than to buy your first home – you lose the 25% government bonus

Can I transfer money between ISAs?

You can transfer money held on one ISA to another of the same or different type at any time. However, it’s important to read the terms and conditions of your ISA before making withdrawals because taking money out could result in your savings losing their tax-free status. Where possible, move money directly from one ISA to another without any break in this chain. 

The process of transferring money from one ISA to another shouldn’t take more than 15 working days between cash ISAs and 30 calendar days for most other transfers. 

Transferring investments from an innovative finance ISA can take longer due to the terms of the agreement. 

How do I choose the best ISA?

Choosing the right ISA depends on your financial goals and how you plan to use your savings. If you’re looking for a straightforward way to earn tax-free interest while keeping easy access to your money, a flexible cash ISA could be a solid choice. But, if you have a specific goal in mind, such as buying a home or saving for retirement, a lifetime ISA might be more beneficial due to the 25% government bonus. This does, though, come with restrictions.

If you're comfortable with taking some degree of risk in pursuit of higher returns, a stocks & shares ISA or an innovative finance ISA could be worth considering. However, it’s important to understand that investments can fluctuate in value, and in the case of innovative finance ISAs, your money isn’t protected by the Financial Services Compensation Scheme.

Alternatively, if you’re happy to lock your savings away for a set period, a fixed term cash ISA can provide a guaranteed return. Ultimately, the best ISA is the one that suits your needs, so it’s worth comparing your options carefully and making sure you understand any risks before making a decision.