Taste the difference: understand the different flavours of ISA

Hello again! In my last blog, I explained that, whether you’re an experienced saver or simply dipping your toes into the savings pool, understanding ISAs — and the tax-free growth they offer — is key to maximising your savings potential.

As promised, in this blog I’ll be delving into the 5 different types of ISA. Sticking to the supermarket theme, by the end, you should be able to taste the difference between the different flavours available! (If you’ve no idea what I’m on about, check out my last blog.)

A quick recap

At the basic level, ISAs (Individual Savings Accounts) are accounts that let UK taxpayers save up to £20,000 each year without paying any income or capital gains tax on the growth — whether that be interest or investment returns, although this is dependent on your individual circumstances.

There are 5 different types of ISA to choose from, each offering a unique benefit. You can choose to invest your entire yearly allowance into a single type of ISA, or you can spread it between several types of ISA to better suit your individual savings needs and risk appetite.

Now, without further ado, let’s dig in!

1. Cash ISAs: The most vanilla of ISAs

A cash ISA pretty much works like an ordinary savings account, except you get the added bonus of not having to pay tax on the interest you earn — before you get too excited, it’s worth understanding whether the tax benefits apply to you first.

Cash ISAs are a great option if you’re looking for a safe place to stash some cash. And they’ve become a lot less boring in recent years as interest rates have skyrocketed. In fact, the current rates offered on many cash ISAs make it possible to earn real returns (in other words, returns that beat the rate of inflation) with no risk — you can’t turn your nose up at that!

As I mentioned in my first blog, within cash ISAs, you have two options:

1. Fixed term: If you’re comfortable locking your money away, you could opt for a fixed term cash ISA, whereby you’ll be paid a guaranteed interest rate for the duration you choose, typically between 1–5 years. Although these ISAs are ‘fixed’, it’s usually possible to access your savings before the fixed term ends, provided you’re willing to pay an interest charge or penalty fee. Fixed term cash ISAs are a useful option if you’re pretty sure you won’t need to access your money for a set time but would like the reassurance to know you can if you need to.

2. Easy access: Alternatively, if you’d like more access to your savings, an easy access cash ISA is likely a better option. These offer a variable interest rate — which means the interest rate can go up or down — but provide less constraints to withdrawing your money. If you opt for an easy access cash ISA, it’s worth considering a ‘flexible’ one, this gives you the ability to move your money in and out without affecting your annual allowance. Zopa offers a great flexible easy access cash ISA that's currently offering 5.08% AER to new customers.†

Historically, fixed term cash ISAs have offered better rates in exchange for holding onto your money for longer. But, given the expectation that interest rates will fall over the coming years, many easy access cash ISAs are currently offering higher rates than fixed term ones.

If you’re struggling to make your mind up between a fixed term and easy access cash ISA, there are some providers, like Zopa†, that let you split your savings between both within a single cash ISA. Zopa enables you to mix and match up to 20 savings pots to create a combination that suits you. Plus, their app-only service means you can open, manage, transfer and withdraw your ISA in just a few taps. You can save between £1 and £250,000 with Zopa, and it’ll be FSCS protected up to £120,000.

To summarise, a cash ISA could be a good option for you if you’d like to earn a reasonable return on your savings while keeping them safe and accessible.

2. Stocks and shares ISAs: A more flavoursome ISA

Stocks and shares ISAs allow you the opportunity to invest in stocks, bonds and other assets all within a tax-free ISA wrapper. The benefit being that you can unlock the potential to out earn the interest you can get on a cash ISA — although this doesn’t come without risk. It’s important to understand that if the investments in a stocks and shares ISA perform poorly, you could get back less than you put in.

While you can technically withdraw from a stocks and shares ISA whenever you like, you may not want to do so when markets are down, and you could get back significantly less than you invested. This means a stocks and shares ISA is usually a better option for long-term savings, typically 5+ years, when investment volatility can be smoothed out.

It’s also important to know that when you do choose to withdraw from a stocks and shares ISA, there’s likely to be a delay between submitting your withdrawal request and actually getting your hands on the money. This is because your investments will need to be sold.

In short, stocks and shares ISAs are more suited towards longer-term savings goals, and you must be willing to weather turbulent markets.

3. Innovative finance ISA: The whacky, sprinkles galore of ISAs

Innovative finance ISAs (IFISA), are similar to stocks and shares ISAs in that your money will be invested for a greater potential upside. However, rather than investing in traditional assets, like stocks and bonds, your money will be used for peer-to-peer lending. This means it’ll be lent to individuals or businesses in return for interest. Although not guaranteed, the interest offered on IFISAs will likely exceed that offered by cash ISAs. That said, with this comes the risk that the individuals or businesses you lend to aren’t able to pay you back, and you could therefore lose the money you put in. In addition to the risk of default, IFISAs are the only type of ISA not FSCS protected.

To conclude, IFISAs present a niche opportunity for a more seasoned investor to diversify their portfolio away from traditional assets, like stocks and bonds.

4. Lifetime ISA: The Neapolitan of ISAs

Lifetime ISAs (LISAs) allow you to save towards multiple goals within one, delicious package — hence the Neapolitan.

You can save up to £4,000 of your £20,000 allowance per year into a LISA in return for a 25% government bonus — that’s £1,000 up for grabs each tax year! You can choose to split your savings between cash, stocks and shares or both.

You can pay into a LISA between the ages of 18 and 50 (although you must open and fund the account before you turn 40), giving you the potential to earn a whopping £32,000 in government bonuses! You’ll no longer be able to contribute to your LISA after the age of 50, but it’ll remain open, and you’ll continue to earn interest or investment returns on your money.

But remember, there’s no such thing as a free lunch. The government have put a few rules around what you can use your LISA for:

Your first home

a. The property must cost £450,000 or less and be bought with a mortgage at least 12 months after you first paid into your LISA.  

b. You must use a solicitor to support your purchase as your savings will be sent through them.  

c. You can use your LISA to buy with someone else (and you can combine your LISA savings with theirs too), so long as you’re both first-time buyers.

Retirement

You can access your savings, penalty-free, when you hit 60.

Watch out though, because if you fail to adhere to the spending rules above, you’ll face a withdrawal charge of 25%. This not only deducts the bonus you’ve earned, but also whacks a penalty fee on for good measure. In practice this means, if you’d saved £800, and earnt a 25% government bonus of £200, this would bring your total savings up to £1,000. Then, if you were to withdraw this money for reasons outside of the ones listed above, you’d have to pay a 25% withdrawal charge of £250, leaving you with £750 (£50 less than you put in).

So, while a LISA is an extremely attractive option for many, before opening one, it’s important you’re confident that you’ll use the savings to either buy your first home worth £450,000 or less or keep it tucked away until you reach the ripe old age of 60.

5. Junior ISA: The chocolate sauce of ISAs

Junior ISAs are a way to give a child under 18 and living in the UK a financial head start in life. You’ll be able to contribute up to £9,000 into Junior ISAs each tax year. Don’t worry, this won’t come out of your own allowance — it’s the chocolate sauce on top, so to speak!

Similar to LISAs, you can opt to have the money split between cash and stocks and shares if you wish — although you’d have to open a separate Junior ISA for each.

When the child reaches 18, the Junior ISA will automatically become an ordinary ISA (whether that be a cash or stocks and shares ISA). From this point, they’ll be able to manage the ISA — and withdraw from it — themselves.

To summarise, Junior ISAs are a sensible option for those looking to save for their child’s future. But before you go wild, it’s important to remember that any money you put into it will belong to your child, and you won’t be able to access it yourself — so don’t save more than you can afford.

The cherry (or flake, take your pick!) on top

Whatever type of ISA you choose, the way you manage it will depend on the provider. Unlike ordinary savings accounts, some ISAs will require you to phone them to withdraw, while others will ask you to print, complete and post lengthy paperwork to request a transfer.

That said, there are some providers, like Zopa†, that offer the convenience you’ve come to expect in this day and age. Zopa offers an app-based cash ISA, which means you can open, manage, transfer and withdraw your ISA in just a few taps from the comfort of your sofa.

Stay tuned for my next blog where I’ll be spilling the beans on how to become an ISA millionaire.

Disclaimer:

The views expressed are those of the author. This blog is intended for information only and doesn’t constitute financial advice. You should always do your own research to ensure anything you apply for is suitable for your specific circumstances.

Tax treatment depends on individual circumstances and may change. Interest rates are correct at the type of writing by may go up or down in the future. If you choose to invest, you may get back less than you put in.

†Smart Saver account and minimum £1 required. ISA Access pots 5.08% AER (4.96% gross) variable, payable monthly. This includes a 1-year fixed bonus rate of 0.5% AER/gross, which starts from the date you open a Smart ISA.

AER stands for 'annual equivalent rate'. We pay you interest on a monthly basis, but AER shows you the rate you’d get if this monthly interest was compounded and paid once a year instead. We provide an AER to make it easier for you to compare our rates with other providers.

Gross is the rate of interest we apply to your money, before any tax is taken off.

This blog was updated on 17th May 2024.