Cash ISAs (Individual Savings Accounts) are savings accounts available to every UK citizen and Crown dependency aged 18 years or over which are exempt from income tax on the interest accrued. The 2013/14 tax free allowance is set by the UK Government for Cash ISAs is £5,760. This is the amount that you can deposit in an ISA over a single tax year. This allowance is reviewed by the Government annually.
Although there are other types of ISA available, such as the Stocks and Shares ISA, for the purposes of this guide we’re going to focus on the most common type of ISA; the Cash ISA.
Understanding how the Yearly Tax Free Allowance Works
Once you have met the yearly tax free allowance for any given year you may not add additional funds, even if you have previously withdrawn these funds. Once the money’s in, it’s best that it stays in. This means if you have £5,760 sat in an ISA and you withdraw £2,000 in September 2013, you will only be earning tax free interest on the remaining £3,760 until April 2014, at which point you can invest any amount that does not exceed the newly announced tax free allowance for 2014/15.
Some ISAs also come with penalties for early withdrawal and so it’s important to realise that ISAs are for long term savings and shouldn’t really be treated as easy access bank accounts (although many accounts offer more flexible withdrawal options). ISAs with penalty free withdrawals tend to offer lower interest rates than those that don’t though.
Many ISAs pay out bonuses after a year or more but these bonuses can often be one offs and so it’s important to keep shopping around to find the best ISA to put your money. You can take out one Cash ISA with one provider per tax year but you can hold funds in multiple ISAs at any one time.
Finding the Right Type of ISA for You
There are many types of ISA providers out there and finding the best ISA account will inevitably take a good deal of research and consideration. It’s important to first of all work out what kind of ISA will suit you. Do you want easy access to your money without incurring fees? Do you want to invest most or all of your yearly allowance in one go or do you wish to pay it in incrementally over the year?
There are two main types of Cash ISA that between them satisfy most types of saver. These are Fixed Rate and Regular Savings.
Fixed Rate Cash ISAs
A Fixed Rate Cash ISA offers a fixed rate of interest over a fixed period (usually a year). Depending on the terms and conditions of the account any withdrawal made during this period may cause the interest rate to drop to a lower rate and be backdated to the point at which the ISA was taken out.
Whilst some fixed rate ISAs will allow a minimal number of withdrawals (often one per year) it’s important to understand that the more access you have to your money the lower the interest rate will tend to be. With this in mind a fixed rate ISA should only be an option if you don’t think you’ll require urgent access to your savings in the immediate future.
Regular Savings Cash ISAs
Regular Savings ISAs allow savers to invest their yearly tax free allowance over the tax year in increments. As such these accounts are subject to lower overall interest rates due as the interest are dropped every month.
Let’s take an example: If you were to invest £480 in April (1/12th of your tax free allowance for 2013/14) then you would receive the full rate of interest for that month. When you came to invest another £480 in May however, you would only receive 11/12ths of the interest rate as there are now only 11 months remaining in the tax year. By March 2014 you’d only be earning 1/12th of the interest rate.
Like Fixed Rate ISAs, Regular Savings ISAs may incur a penalty if money is withdrawn over the year or they may have a withdrawal limit or a set notice period. Again, consider whether you require easy access to your money and most importantly of all, do your research.