Top ISA dos and don'ts

Millions of savers have an ISA, but how many are getting a good deal? Here's how to make the most of these tax-free savings accounts.

Back in August 2005, a survey by the Prudential found that a tenth (10%) of 18-24 year olds thought an ISA was an energy drink, with one in seven (15%) believing that it was an iPod accessory. Oops!

It's ISA, not iPod

In fact, ISA stands for 'Individual Savings Account' and it's simply a tax-free wrapper around a savings account or clutch of investments known as a stocks and shares ISA. Put simply, an ISA enables you to make money without sharing your gains with the taxman.

Alas, governments work in mysterious ways, so the ISA regime is far more complicated than it needs to be. That said, here are the basics:

How ISAs work

1. To open a cash ISA, you need to be 16 or over; for a stocks and shares ISA, you must be at least 18.

2. ISA allowances follow tax years: they run from 6 April one year to 5 April the next. Currently, we're in the 2010/11 tax year, with the 2011/12 tax year beginning on 6 April 2011.

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3. Your yearly ISA allowances are £5,100 in cash plus £5,100 in investments, for a total of £10,200. However, from 6 April 2011, these limits rise to £5,340 each, for a total allowance of £10,680.

4. If you put nothing into a cash ISA, then your entire allowance (£10,200) can go towards a stocks and shares ISA.

5. If you use up your entire ISA allowance in one year and then make a withdrawal, then you cannot re-deposit this money back into the same ISA. Instead, you must wait until the start of the next tax year before re-depositing your cash in a new ISA.

6. Your cash ISA and shares ISA can be with different providers, and you can transfer your accounts between ISA providers.

Top tips for an ideal ISA

While the above rules apply to all ISA accounts, not all cash ISAs are the same. Like other savings accounts, interest rates vary enormously, so it pays to shop around. In addition, access to your cash varies; some ISAs offer easy access, while others have notice periods or offer fixed-rate, fixed-term deals where you money can't be taken out.

For a nicer cash ISA, here's a list of three dos and three don'ts to help make the most of your annual allowances:

DO seek out the highest interest rates

With the Bank of England's base rate at an all-time low of 0.5%, the interest rates paid by cash ISAs are a lot lower than they were a few years back. That said, as the end of the current tax-year draws closer, several lenders are introducing better and better rates of interest.

So make sure you look for the very best interest rates when you open a new ISA. Don't just stick with the same old bank or building society year after year, or you'll get taken for a ride. Instead, shop around for the highest-paying cash ISAs.

At the moment the best rate for new ISA money is available from the Santander Loyalty Flexible ISA which has just increased its rate to 3.50% (tracks 3% above base rate for 12 months). However, you must be a Santander current account customer and pay in at least £1,000 a month, or have a mortgage or investment product with Santander.

Alternatively, the AA Internet Access ISA pays 3.35%.

Meanwhile, the Halifax Direct Reward ISA offers a rate of 3.20% for current account holders, or 3% for non-current account holders on money which has been transferred from an old ISA.

DO transfer to the best rates

As well as looking for the best rates for your new ISA money, do the same for your existing accounts. You can transfer existing cash ISAs to a higher-paying bank or building society. However, this transfer must be carried out by the providers - if you close your ISA and withdraw your cash, then that allowance is gone forever.

What's more, by locking away your ISA cash for an extended period of say five years, you can earn fixed rates as high as 5% a year on current rates. Then again, don't tie up any money that you will need to dip into in an emergency, as access to these fixed-rate accounts is restricted or forbidden. Find out more in Earn 5% on your savings, tax-free.

DO use up your allowance

Unfortunately, if you don't use up one year's ISA allowance, then it is lost forever when the next tax year begins on 6 April. So, save as hard as you can inside cash ISAs, because you know it makes sense.

DON'T fund and forget

In the financial world, loyalty is for dogs. In other words, the best deals are often available only to new customers and not existing savers. Hence, never stop thinking about your ISA savings. Always keep a close eye on the rate you're getting and don't hesitate to move when it is no longer first-class.

DON'T wait until the last minute

At the end of the tax year, and particularly in the first few days of April, there's a mad dash to open new cash ISAs before the 5 April deadline. This rush perfectly demonstrates the madness of crowds. The smart thing to do is to open your ISA as early as possible, not as late as you can. That way, you can start earning tax-free interest from the very earliest possible date.

DON'T pay tax needlessly

Lastly, work out how much of your existing non-ISA savings can be transferred into cash ISAs. By moving as much as you can inside this tax-free shelter, you can avoid future tax on your savings interest.

In summary: why pay tax when you don't need to? Move your taxed savings into a cash ISA today!

This is a classic article that has been updated for 2011.

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