The ISA is a powerful tool that everyday citizens can use to grow their wealth to its full potential. However, there are several factors that you should be aware of in order to get the most out of this instrument. With savings accounts paying less in interest in 2013, it can be tempting to pull cash out of your ISA, but by doing so, you could end up paying more in taxes.
The ISA
An individual savings account is a powerful alternative to standard savings accounts because of one key difference between them: The ISA is–up to a point–a viable tax shelter. When you withdraw money from any standard savings account, you will find yourself immediately hit with at least a 20 percent tax on any interest you earned. With an ISA, on the other hand, your cash, dividends and capital gains are all exempt.
The ISA was developed in 1999 as a replacement for personal equity plans, which, while popular with the middle class, were not embraced by other economic classes. The ISA addresses this issue by making it possible to earn tax-free capital gains beyond £10,000 per year.
There are two types of ISA: the standard cash ISA and the stocks and shares ISA. The cash version is simply a tax-free savings account, and it offers either fixed AER or variable, with the variable option being the most common. Many ISAs also come with a guaranteed base rate, meaning that you will always earn some interest on your money, regardless of the state of the economy.
The stocks and shares ISA offers much more flexibility in that you can invest in bonds, public stocks, trusts and open-ended investment companies. While this can give your money much more room to grow, it’s important to keep in mind that these securities can lose value as well.
The savings power of an ISA is not limitless. In fact, there is a hard limit baked right in known as the “ISA allowance.” This allowance represents the total amount of tax-free money that you can deposit each year. The allowance varies year to year, and the total for 2013 is £11,520. Put another way, you can earn tax-free interest on up to this amount each year, but deposits beyond that will be taxed at the normal rate. Additionally, only £5,760 of this amount can come from cash deposits.
Investing and Interest
ISAs typically offer interest rates on par with other savings accounts, and this is primarily determined by the base rate set by the Bank of England, as well as the overall state of the economy. 2013 has seen a general downturn in interest rates primarily due to the funding for lending scheme. This scheme–initiated by the Bank of England–seeks to provide banks with extra funds so that they can offer consumers attractive interest rates on secured loans. The immediate result is that banks are focusing more on attracting loan consumers and less on attracting savers. Less competition among banks results in lower ISA interest rates. In fact, The average ISA rate in 2013 was 1.74 percent, down from 2.55 percent in 2012.
Sylvia Waycot of the financial information company Moneyfacts has said that most new ISAs are opened in January and February of each year, but that there was a significant decline in the number of new ISAs opened in 2013. If you are opting to spend your cash instead of saving it due to lower interest rates, keep in mind that you can convert your cash into stocks or bonds with a stocks and shares ISA. While the interest rate on the ISA itself may not be high, you can still experience high gains over time with a diverse portfolio. Additionally, if you earn more than than £10,600 in capital gains outside of the shelter of an ISA, you will pay a good portion of that to the government in taxes. Likewise, if you earn dividends on your shares, you will be taxed at your tax rate outside of an ISA–which can soar as high as 37.5 percent–whereas dividends are always taxed at 10 percent from within an ISA regardless of your income.
Limitations
There are several limitations that you should be aware of before investing in an ISA. Most significantly, your ISA allowance is a finite resource. For instance, if you invest £1,000 in cash at the beginning of the year and then withdraw it, you can then only invest an additional £4,760 in cash for that fiscal year. The same goes with stocks, so you will have to carefully weigh the benefits and risks of withdrawing your funds once deposited. However, if you do withdraw your funds early, you will receive all of the interest that you have accrued up to that date.
You can, at any time, switch ISA providers. However, you must first file a transfer form to do so. If you withdraw the funds without filing this form first, you will have to pay taxes on all of the interest the account has earned. You can procure the appropriate form from your current ISA provider. One final limitation to be aware of: you cannot use money in an ISA as collateral for a secured loan. This is primarily because you can withdraw money from an ISA at any time. You can, however, often use a certificate of deposit as collateral.