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What is an ISA and how do they work?

Looking to make more of your savings? ISAs are individual savings accounts that can offer tax-free interest payments. 

Read on to find out everything you need to know about the meaning of an ISA and how ISAs work.

What is an ISA?

An ISA can offer a unique way to earn tax-free interest on your savings. They can be a great way to maximise on your savings and shield them from income, capital gains and dividend tax. All you need to do is follow specific terms and conditions in order to qualify for the tax-free growth.

How do ISAs work?

ISAs can maximise the benefits of your savings since the interest earned on the money saved is not taxable. However, certain exemptions apply to Capital Gains Tax (CGT), tax on bond interest, and tax on dividend income if the ISA is a Stocks & Shares ISA.

Every tax year you’re able to save or invest a certain amount of money in an ISA without paying tax on your returns. The tax year runs from April to April each year but your savings accounts will continue beyond this unless you choose to close them.

What different types of ISAs are there?

There are four different types of ISAs. These are: 

  • Cash ISAs
  • Stock and Shares ISAs
  • Lifetime ISAs
  • Innovative ISAs. 

It’s important to remember that you can only invest in, or open, one of each type of ISA per tax year.

Cash ISA

A cash ISA can either have a fixed or variable rate. If you would like to be able access to your money frequently, a Variable Rate Cash ISA could be right for you – but the interest rate you’re offered will be variable.

Find out more about the Sainsbury’s Bank Variable Rate Cash ISA.

A Fixed Rate Cash ISA could potentially offer a higher interest rate, for a fixed period of one to five years, but your money will have more restrictions on it. 

Find out more about the Sainsbury’s Bank Fixed Rate Cash ISA. 

Stocks & Shares ISAs

A Stocks and Shares ISA allows you to invest in a range of assets, and any investment or growth earned is tax-free.

The assets you may invest in include:

  • Cash
  • Shares
  • Bonds
  • Exchange Traded Funds (ETFs)
  • Unit trusts
  • Investment trusts
  • Open Ended Investment Companies (OEICs)

This type of ISA may be suitable for you if you don’t require regular access to your money, and you’re happy to leave the investments for a number of years. But, be sure to bear in mind that your investments could rise and fall in value with this type of ISA and you could get back less than you paid in.

Lifetime ISAs

A Lifetime ISA is designed to help you save for something big – like buying a home or fulfilling retirement plans.

Each tax year until you are 50 years old, you may save a maximum of £4,000 in a Lifetime ISA. All subscriptions up to this maximum will receive 25% extra from the government – so you could earn an extra £1 for every £4 you save. Find out more at gov.uk.

Innovative Finance ISAs

This ISA adds a ‘tax-free wrapper’ to savings income made from peer-to-peer lending. Simply put, you’re effectively lending your money to borrowers in exchange for interest (which is tax free). It’s important to note that it is a higher risk option as your money is in peer-to-peer investments and it’s not protected by the Financial Services Compensation Scheme. 

How much can you put in an ISA?

You can currently put up to £20,000 in an ISA each tax year. This is a rule that is set by the government and can be split across all four different types of ISAs. 

For example, you could save £6,000 in a Cash ISA, £4,000 in a Lifetime ISA, £5,000 in a Stocks and Shares ISA and £5,000 in an Innovative Finance ISA.

If you exceed this maximum ISA allowance, you won’t receive tax relief on the extra amount that you’ve saved. 

How many ISAs can you have?

You may have as many ISAs as you like – as long as you meet the eligibility requirements and stick within the savings limit – but you can only open or invest in one of each type of ISA per tax year.

Personal Savings Allowance 

Each year, the government sets individuals a Personal Savings Allowance (PSA). This impacts the amount of interest you can earn during a single tax year. ISAs are exempt from the Personal Savings Allowance.

The allowance that you’re eligible for depends on the rate of tax that you pay, you could earn up to £1,000 tax-free interest on your savings. 

Basic rate taxpayers (paying 20%) can earn up to £1,000 tax-free interest each year, whereas higher rate taxpayers (paying 40%) can earn up to £500. At the higher end of the spectrum, additional rate taxpayers are not eligible for any interest-free allowance.

Now you have a better understanding of how an ISA works in the UK, get started by exploring the range of savings accounts on offer at Sainsbury’s Bank today.