ISAs are a popular investment choice for people looking to do more with their savings. ISAs can hold either cash or stocks and shares and typically offer a more tax efficient way to invest than you would typically find in high-street bank savings accounts.
For a first-time investor, a stocks and shares ISA can be a great place to start, although it all depends on your financial goals and your risk tolerance as an investor. Nevertheless, a properly managed ISA can represent a good way to diversify your investment portfolio, keep things tax efficient, and prevent it from becoming too ‘top heavy’ with high-risk ventures.
Keep in mind that there is no universally ‘best ISA’ out there. Each option comes with its own pros and cons, and whether or not it looks ideal for you will depend on your finances, your financial goals, and how much you’re looking to invest each year. You’ll want to seek sound financial advice before you come to any conclusions or risk putting your money somewhere suboptimal.
Here are three things you need to keep in mind about ISAs before you commit your money to one.
1. What is an ISA?
ISA stands for Individual Savings Account. They enable you to invest money in cash or stocks and shares without incurring any income, capital gains or dividend tax on the returns your ISA generates for you.
Everyone is bound by the yearly ISA allowance, which determines how much of their money they can invest into an ISA (or multiple ISAs) in any given tax year. Right now, the allowance is set at £20,000.
Within a stocks and shares ISA you can hold a variety of different investments which means you can avoid putting all your money into one basket and ensure your investment portfolio is sufficiently diversified.
2. The different types of ISA available
You can choose from four different types of ISA: stocks and shares, cash, innovative finance, and lifetime ISAs. The type of ISA you choose will impact what happens to your money, the length of time it will take for you to see a return, how much you’re allowed to pay in each year, and whether you’ll need to pay a withdrawal charge when that time comes.
For instance, lifetime ISAs (LISAs) are designed to help you work toward retirement or, alternatively, buy your first home. They’re a good resource to invest in since the government pays a 25% bonus each year. If you pay in £4,000 (the current yearly limit for LISAs), then the government will top that up with a further £1,000, for instance. But, if you choose to cash that ISA for something other than retirement or a house purchase, you’ll need to pay a 25% withdrawal charge.
Other ISAs enable you to invest the full yearly allowance. You can split this allowance, but you can’t carry it over into the next tax year.
Some ISAs are also lower risk than other ISAs. Stocks and shares ISAs are not secured against loss. A key reason why cash and lifetime cash ISAs are a great option for new or nervous investors is there is no risk of you losing your money. Investments typically offer a higher potential payoff because of the fact that they take more risk in return for the potential to achieve a better return. Cash ISAs may fall behind the rate of inflation, which isn’t optimal for your ability to generate a good ROI, but you’re not at risk of actually losing money.
3. The downside to ISAs
As we mentioned above, a key downside to focussing on cash ISAs is the relatively low real yield they promise. When investing, low risk is almost always correlated to a lower return.
If you have significant funds to invest that exceed the yearly limit of £20,000, then there’s a definite limit to the amount of value ISAs can offer to you.
What’s more, for cash ISAs any gap between interest and inflation means that, while you’re not actually losing money, the overall value of your money will go down in real terms. This is the experience for many cash ISA investors across the UK right now, with inflation high and bank interest rates low.
Even still, they can be a great addition (or starting point) for investors, provided you get the right advice on the best options for you.
The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.