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How do ISAs work?

If you live in the United Kingdom, you may be eligible for an individual savings account (ISA). These accounts allow you to earn interest on your savings, without needing to pay any income tax. However, you will be limited in how much you can put into your account. This was done by the government to encourage people to start investing or saving. As such, while not technically considered an investment in its own right, an ISA can help you to protect your investments and savings from tax on interest, dividends, and capital gains. Therefore, it may be a good idea to trade or invest in ISAs.

Before you start ISA trading or investing, it is important that you understand exactly what they are, and how they work. In this article, we attempt to explore this topic below in more depth. If you are interested, keep reading to find out more about ISAs.

What are ISAs

As stated previously, an ISA allows its holders to earn interest on any cash savings or investments. However, unlike normal accounts, they do not need to pay any income or capital gains tax, as well as interest on cash. ISAs have introduced over a decade ago in order to encourage more citizens to save up for their future. As such, one of the main draws is that it can be used to save cash, invest, or lend money in a tax-efficient way.

There are generally four types of ISAs. These are:

  • Cash ISAs
  • Innovative Finance ISAs
  • Lifetime ISAs
  • Stocks and shares ISAs

Most people tend to use a Cash or Stocks and Shares ISA. However, you can only pay into one kind of ISA each tax year. Fortunately, you can open a new ISA with another provider every year if you wish to do so.

How do they work

Before you start investing in an ISA, it is important to understand how they function. Each UK Tax year (so from 6 April to 5th April the next year), you are handed an ISA allowance. This allowance lets you save or invest money up to a certain amount that can be tax-free. That certain amount depends from year to year.

Last year, for 2021-2022, the allowance was £20,000. For the 2022-2023 tax year, it is the same as well. This means you have until April 5th to use all of your ISA allowance for the year. If you end up missing the deadline, any extra money to put into an ISA account will be for next tax year’s allowance.

However, one restriction is that you can only put £4,000 in your Lifetime ISA in a tax year. Fortunately, any ISA you have will not close when the tax year ends. You can keep your savings tax-free so long as you keep the money in your accounts.

Who is eligible for an ISA?

While ISAs sounds like a good deal, not everyone is eligible for one! Here are a few of the following criteria below that determine whether or not you can open an ISA.

  • You must either be a resident in the UK, or a crown employee or their spouse (if you live or work abroad)
  • You must be 16 or older to open a Cash ISA
  • You must be 18 or older to open a Stocks and Shares ISA or an Innovative Finance ISA
  • You must be 18 or over but under 40 to open a Lifetime ISA
  • Those who are under 18 can get a Junior ISA if they are accompanied by their parent or guardian

You must also remember that each ISAs can only be held using one person’s name. You cannot have an ISA with joint names.

Types of ISAs available

While we have previously mentioned that there are four different types of ISAs you can choose from, they each have their own peculiarities. Here is a little bit more information on them down below:

Cash ISAs

Cash ISAs work the same as any type of savings account, except that they are tax-free. This is great for investors who are very risk-averse, as you cannot end up with less cash than you put in. But because interest rates are so low, inflation could mean that the total amount of cash in your account could end up being worth less in the future than it is now. There are a few basic kinds of Cash ISAs:

  • Fixed term: this is where your cash is tied up for a fixed term, meaning that you receive a fixed rate of interest.
  • Limited access: This means you can only deposit or withdraw money a certain number of times. If you go over this limit, your interest rate may drop – or there may be other penalties.
  • Instant access: This is where you can put your money in and take it out whenever you need to. If you have ISA flexibility, this means it will not impact your ISA allowance.

Additionally, a ‘help to buy’ ISA is also classified as a type of Cash ISA.

Stocks and Shares ISAs

As its name suggests, these are stocks ad shares investment accounts. This means they allow investors to invest in a wide variety of financial instruments and make use of tax benefits. This ISA is slightly more risky than a Cash ISA, but it can also be more rewarding too. This is because investing in the stock market means that your funds will be impacted by market fluctuations, whether the market moves for you or against you. That being said, you also have the potential to get dividends, which are free from tax too! Before opening a Stocks and Shares ISA, it is always good to remember that your investments may fall in value, so you could get back less than your original deposit. It is best that you invest for a least six years so that you can beat inflation and weather out any potential pitfalls in the market.

How to open an ISA

Fortunately, with the way technology is rapidly developing, you can open an ISA through a branch, by the post, the phone, or online. It all depends on what account and the provider you choose. When you open it, you will have to put some money in it, so your initial funds will have to cover the account’s minimum amount. This minimum amount can vary from provider to provider.

Much like opening a bank account, you will also have to give some personal information to your ISA provider. This includes:

  • Your full name
  • Your address
  • Your National insurance Number

Afterward, you will be prompted to read and sign the ISA declaration, which tells you how that particular ISA works. Always make sure that you read it thoroughly before signing, as the contract may include important restrictions and whether you have withdrawal penalties.

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