Types of ISAs Explained: Which ISA is Right for You?

INTRODUCTION • WHAT IS AN ISA • ISA TYPES • IMPORTANT CONSIDERATIONS • WHICH TO CHOOSE • CONCLUSION

Introduction

Have you ever sat down to sort out your finances and been faced with hundreds of options and countless pieces of conflicting "advice"? We'll discuss the different types of ISA and provide a way to decide which is best for you.

What is an ISA

An ISA (individual savings account), is an account which is protected from the tax man with no limit on how much interest, capital gains or dividends you earn. Let's use an example to illustrate that: If you have £25,000 in an account earning 5% interest, that's £1250 interest per year. The first £1000 (most people's personal savings allowance) of that you can keep, but the tax man will want a portion of the remaining £250. This will be taxed at your usual income tax rate. Note that the £1000 is different to your £12,570 personal allowance.

ISA Types

There are four types of ISA and they all serve a different purpose.

Cash ISA:

The purpose of a cash ISA is, unsurprisingly, to hold cash. Usually this is money that is kept liquid while earning either a guaranteed interest or a variable rate. This has been quite good recently as the bank of England base rate (which loosely sets the interest rate) has been quite high. However if it drops below inflation, your money will be decreasing in value.

Stocks and shares ISA:

If you want to invest your money, which I suggest most people do, this is the type of ISA for you. With this type you can hold shares in predominantly companies and exchange traded funds in any stock market that's supported by your chosen provider. This is often suggested if your time horizon is at least 5 years but, historically, the longer you are invested for, the higher chance you have of getting a positive return.

Lifetime ISA:

A lifetime ISA, often referred to as a LISA, has the advantage that it gives very good short term gains if you have a specific use. To open one of these you need to be between 18 and 40. This type of ISA has a 25% contribution from the government up to £1000 and the maximum you can contribute to this type is £4000/year. The use cases for this is to purchase your first home, for retirement only, or if you're terminally ill with less than 12 months to live. If you access these savings for anything other than those reasons, you will have to pay a 25% charge which effectively brings it down to a cash ISA with a poor interest rate.

Innovative finance ISA:

This is the least common type of ISA that allows you to invest in peer-to-peer loans, less-liquid investments or cash. Peer-to-peer loans cut out the bank and directly connect the lender and the borrower allowing the lender to potentially get higher returns as they get to decide which individuals to lend to. This could also lead to higher losses if the borrower cannot repay although most providers have some sort of back up in that case (this is not guaranteed though). Withdrawing money from a IFISA can be slow (more than 30 days) so if you may need access the cash quickly, this may not be a good choice for you.

Important Considerations

Another key factor is the Financial Services Compensation Scheme (FSCS) which provides some protection if your provider who holds your cash goes bust (along with your cash!). If a provider is under the FSCS, any cash worth up to £85,000 will be returned to you. Other investments may be protected, take a look here to find out more. The first three types of ISA are covered by this scheme however, an Innovative Finance ISA is not protected so that is something you need to consider when choosing the right ISA (or ISAs as you can have as many as you like) for you.

There is a limit of £20,000 on how much can be contributed to you ISAs each year. This applies to all of you ISAs combined and you're free to allocate different parts of that £20,000 to which ever ISAs you like.

If you start investing with a company and want to switch to another, don't sell your investments and withdraw your cash to pay it into another provider, this will eat into your allowance. You will be able to request an ISA transfer which is arranged between your old and new provider. Note that some providers only allow a full transfer meaning you need to transfer all of your funds.

Which ISA Should You Choose

Most people benefit from using 2 or 3 ISAs. A cash ISA so you earn interest on an emergency fund. Think unexpected expenses like car repairs or your boiler dies. This is usually 3 - 6 months of living costs. This could also be in Premium bonds but I'll write a post on that in the future.
If you're not a home owner, and want to be, use a Lifetime ISA to make the most of the extra cash courtesy of the government. For longer term investments outside of a pension. I would use a stocks and shares ISA to maximise returns while weathering market volatility.
After a few years of this and you're a lot more confident, you could consider using a IFISA account. Or just be happy with what you're doing in the other accounts.

Conclusion

Whatever your goals are, and how long you have to get there, choosing the right mix of ISAs gets you on the right track. It will likely take time to get there so start looking at your options today. Remember, you can use multiple ISA types simultaneously within your £20,000 annual allowance.

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Disclaimer

The usual disclaimer: I'm just a guy on the internet sharing what I've learned. This isn't financial advice so do your own research and speak to a qualified adviser about your specific situation.