Over 19 million 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 ISAs, 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 2009/10 tax year, with the 2010/11 tax year beginning on 6 April 2010.
3. If you were born on or before 5 April 1960, then your yearly tax-free ISA allowance is £10,200. Up to £5,100 of this total can be saved in a cash ISA, with a further £5,100 available to shelter gains from shares, funds, bonds and other investments. in a stocks and shares ISA.
4. If you're under fifty, then your yearly ISA allowances are £3,600 in cash plus £3,600 in investments, for a total of £7,200. However, from 6 April 2010, these limits rise to £5,100 each, for a total allowance of £10,200.
5. If you put nothing into a cash ISA, then your entire allowance (£7,200 or £10,200) can go towards a stocks and shares ISA.
6. 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.
7. 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% a year, the interest rates paid by cash ISAs are plumbing new depths. As I warned last October in The 21 worst cash ISAs, several cash ISAs pay interest of just 0.1% a year. On a balance of £2,000, this comes to a measly £2 a year.
The simple answer to this savings setback is to 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 First Direct Cash e-ISA with a rate of 2.75%, while the Santander Direct ISA (Issue 6) also offers a rate of 2.75% on money which has been transferred in from an old ISA and it worth £9,000 plus.
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 5 years, you can earn fixed rates as high as 4.6% 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.
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. (Only five million of the 19 million ISA savers use their full ISA allowance. I'd like to see this figure rise steeply, so please do me a favour...)
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. By making use of cash ISAs, basic-rate taxpayers dodge 20% tax (£1 in every £5 made); higher-rate taxpayers avoid 40% tax on their interest (£2 of every £5).
In summary: why pay tax when you don't need to? Move your taxed savings into a cash ISA today!
If you have a specific question about saving tax or boosting your savings, why not ask other readers for help using our excellent Q&A tool? And, if you're having trouble putting money aside find out how to free up some spare cash by joining our Build up your savings goal.
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