The four different types of ISA: Expert explains benefits of tax efficient saving pots

With just over two months of the financial year left, Britons are being warned to “use or lose” their ISA allowance to reap the tax benefits.

This comes as more than four million accounts are currently at risk of tax due to past years’ high interest rates and frozen personal allowances.

There are four different ISAs available and each offers different perks. However, research by Shawbrook found 27 percent of savers lack a clear understanding of the benefits and rules.

Alice Haine, a personal finance analyst at wealth management platform Bestinvest, said: “They may be almost 25 years old, having first been introduced on April 6, 1999, but tax-free ISAs are the must-have financial accessory of the moment when you consider cuts to capital gains tax and dividend allowances and a longstanding freeze on the Personal Savings Allowance.

“Savers aged over 18 can shelter up to £20,000 this tax year in an ISA either in cash or investments, something that is highly attractive for taxpayers because all income and capital gains are tax-free.”

However, sharp cuts to the annual dividend allowance and capital gains exemptions at the start of the current tax year – with both set to halve again from April 6 – should be a wake-up call for savers and investors.

Ms Haine said: “Add the frozen Personal Savings Allowance into the mix and it means savers and investors are far more likely to pay tax on the money they have carefully stashed away, making ISAs more important than ever.

What is an ISA?

An Individual Savings Account (ISA) enables people to save a certain amount of money tax-free. The ISA allowance for the 2023/24 tax year is £20,000.

Ms Haine said: “Tax-free ISAs allow savers to grow their wealth and withdraw investments when they want without fear of a heavy tax bill at the end.”

She added: “Remember, this is a ‘use it or lose it’ allowance because you cannot carry it into the next tax year if it isn’t used.

“No one wants to pay tax on money they have already been taxed on, and savers looking to secure this year’s £20,000 allowance in full before it disappears must fund an account with that amount by April 5.”

Different ISAs for financial goals

Choosing the right type of ISA for certain financial goals is important to ensure people are making the most of their allowance. According to Ms Haine, adults currently have four different types of ISA to choose from, which include:

• Cash ISA
• Stocks and Shares ISA
• Lifetime ISA (LISA)
• Innovative ISA (IFISA).

Ms Haine said: “Cash ISAs are savings accounts that you don’t pay tax on. Like a savings account, there are easy access or fixed rate options, where cash is locked away for a set period.”

The savings expert said Cash ISAs are best for those with a short-term time horizon, who are risk averse and may need access to their money in the next five years. She added: “They are particularly beneficial as an easy-access savings option for additional rate taxpayers who have no Personal Savings Allowance.”

A Stocks and Shares ISA allows savers to invest in shares, funds, investment trusts and bonds with no tax on any gains or income from assets held in the account.

Ms Haine said: “They are best for those with a time horizon of five years or more because financial markets, especially equities, can be volatile over short-term time periods but have historically delivered much higher real returns – that is returns that beat the effect of inflation – than cash over the long term.

DIY investors can choose their own investments or they can choose to invest in a fully managed portfolio, sometimes referred to as a Ready-Made Portfolio.

Ms Haine said: “A Lifetime ISA (LISA) is specifically designed for meeting two goals: either to help purchase a first home or to save towards retirement.

“Savers aged between 18 and 39 can contribute up to £4,000 a year into a LISA, and the Government will top their contribution up by 25 percent. That’s a ‘free cash’ bonus of up to £1,000 a year. After 39, an existing LISA account holder can continue to pay in and still receive the state top-up until they are 50.”

According to Ms Haine, the maximum total amount of bonuses for someone who opened an account at 18 and maxed it out until they hit 50 is £33,000. However, she noted: “There are a few tricky rules. The pot must go towards either the purchase of your first property (capped at £450,000 in value) or be held until you are at least 60. Withdrawals for any other purpose will incur penalties.”

Meanwhile, an Innovative ISA (IFISA) typically enables savers to engage in peer-to-peer lending, allowing people to lend up to £20,000 to borrowers or businesses without getting their money taxed.

How many ISAs can you have?

Ms Haine said the “great thing” about ISAs is that the £20,000 allowance applies across all types of ISA so people can save money in cash, in investments, or both, and split the money across different ISAs.

Ms Haine said: “A savvy saver could store a portion of their savings in the highest-interest Cash ISA they can find and deposit the rest in a Stocks and Shares ISA to take advantage of longer-term investment returns.

“Meanwhile, younger savers wanting to save for a house deposit could store £4,000 in a LISA to secure the maximum £1,000 annual bump up from the government and then spread the remaining £16,000 across a Cash ISA or Stocks and Shares ISA depending on the time horizon for their savings.”

In the past, savers could only contribute to one ISA of each type per year. However, Ms Haine said: “New rules coming into effect on April 6 will allow savers to subscribe to multiple ISAs of the same type, except for the Lifetime ISA, within the same tax year.

“This is useful for investors who want to use more than one provider or have different ISAs for different financial goals.

“For Cash ISA savers, the rule changes will allow them to shop around for the best deals, opening a new account if a more competitive rate crops up and they still have spare allowance to use up.”

While subscribing to more than one ISA of the same type will enhance flexibility, the allowance remains the same, so savers must track contributions to ensure they don’t breach the £20,000 limit.

Ms Haine said: “If they do exceed it, a call to HMRC on 0300 200 3300 is required, who will ensure any interest earned on the money is taxed.”