What is an ISA, and can it grow your cash better than a savings account?

For most UK savers, it’s possible to earn interest tax-free as part of their Personal Savings Allowance. But higher earners are unlikely to qualify for the allowance, meaning that their entire interest income could be subject to tax in a savings account.

ISAs (Individual Savings Accounts) shield UK savings from tax up to an annual limit. But with multiple types of ISAs on the market, each with their own rules, it can be difficult to know whether savers should open an ISA or savings account.

In this guide, you’ll learn what an ISA is and how they differ from savings accounts. Discover the various types of ISA, as well as some of their disadvantages, and the answers to the most common questions to determine how you can grow your savings efficiently with a portfolio of accounts.

What is an ISA?

ISAs let you earn interest and dividends tax free. In the UK, taxpayers over the age of 18 can contribute up to £20,000 annually to these accounts.

You can pay into different types of ISAs within the same tax year, and as of 06 April 2024, you can open multiple ISAs of any type every year.

How do ISAs work?

Your ISA allowance is tracked automatically, and some mobile apps let you see how much you’ve used in the tax year so far. ISAs also benefit from the effects of compound interest, meaning your investments grow faster the more you save.

Once you’ve maxed out your contributions for the year, you can no longer fund an ISA. If you try to exceed your allowance, your funds may be automatically returned to your source account. But it’s important to check the exact process with your provider.

You don’t have to open an ISA with a traditional bank, so it’s worth exploring your options to ensure you get the best rate possible. This is especially important as Flagstone’s recent research found that 58% of savers in the UK keep most savings with the same bank that holds their current account. An estimated £1tn in savings makes less in interest than the Bank of England’s targeted inflation rate.

The five types of ISA

There are five types of ISA, which you can combine for a portfolio of savings options.

What is a Cash ISA?

Cash ISAs operate like savings accounts, where you fund the account and the balance earns interest. As with other types of savings accounts, the interest rate is often higher if you limit your access to the funds. In general, the harder it is for you to withdraw your money, the faster your balance will grow. The range of cash ISAs you can open includes the following types of account:

• Instant access: You can withdraw your money whenever you need it, without penalties. 
• Limited access: You can withdraw your money a set number of times before you’re charged a penalty fee. 
• Notice accounts: You have to give the bank notice before withdrawing your money, or they will charge you a penalty fee. 
• Fixed rate: The interest rate is set when you open the account and doesn’t change, even if interest rates go up or down. If your rate isn’t fixed, it will change over time, which is known as a ‘variable’ rate.

What is a Stocks and Shares ISA?

Stocks and Shares ISAs are investment accounts. You fund the account, then decide where you want to invest. As with similar forms of investing in the stock market, you can either choose to buy shares in a specific company, or buy into an index fund, which splits investments between a group of companies within a category.

How do Stocks and Shares ISAs work?

In a Stocks and Shares ISA, the profit you make is tax free. The limit applies to your contributions, not the amount of profit you make. In theory, you can fund one Stocks and Share ISA with £20,000 within a year if you wanted to, though this would be riskier than spreading your allowance across account types.

The value of stocks and shares change constantly, so it’s important to consider how much risk you can afford to take on when investing. It’s possible to lose the money you invest.

Innovative finance ISA

Innovative finance ISAs (IFISA) are investment accounts, designed to let you offer loans. These include peer-to-peer lending or giving money to a crowdfunding project. You can also use an IFISA to lend cash. Although returns on IFISAs may be higher than other investments, there is a risk you won’t get your money back if the receiver of the loan goes bankrupt.

How does an IFISA work?

You open an account with a lender approved by the Financial Conduct Authority (FCA). Once you fund your account, your money is loaned to the lender’s clients at an agreed rate of interest. The higher the interest, the riskier the investment.

IFISAs are not FSCS protected, meaning that you can lose all the money you invest.

What is a Lifetime ISA?

You can only open one Lifetime ISA (LISA) per person, and that isn’t the only reason this type of ISA is unique. LISAs are designed to help first time buyers get on the property ladder. You can also use LISAs to save for retirement, though there are other methods of doing this which may provide a greater return, such as paying into workplace pension schemes and personal pensions.

How does a Lifetime ISA work?

When you fund a LISA, the UK government pays a bonus into your account. The government bonus is capped at £1,000, which you can only get if you pay in the maximum amount.

The bonus is only valid if you withdraw your LISA’s funds to buy your first home (with valuations up to £450,000), or you’re over 60 years old. If you take out your money for any other reason, you’ll be charged a 25% penalty fee, which will also apply to the interest you’ve earned in the account.

What is the LISA limit?

You can pay a maximum of £4,000 into a LISA every year. If you do this, you can still invest your remaining allowance of £16,000 into other ISAs.

Junior ISA (JISA)

Junior ISAs can help you gift money to children without paying tax. This is because the accounts are designed for parents to contribute on behalf of younger people.

How do Junior ISAs work?

When a child turns 18, they can access the money in their account. Junior ISAs benefit from compound interest, which means that the sooner parents or guardians open an account, the greater the financial rewards for their loved ones.

JISAs can attract a maximum of £9,000 per year, and anyone can pay into one. This hasn’t changed since the scheme was introduced in the 2020/21 tax year.

ISAs vs. savings accounts: the main differences

Depending on your circumstances, you may benefit more from savings accounts than ISAs. As cash ISAs are most similar to savings accounts, we’ll compare the two side by side.

Cash ISAs vs. savings accounts

The main benefit of opening a cash ISA over a savings account is more relevant to those with large amounts of savings. This is because the amount of savings it would take to generate over £1,000 in interest is unlikely to be within reach for basic-rate taxpayers who make less than £50,271 in income.

If you placed £20,000 in an account with a 5% interest rate, you would make £1,000 at the end of the year before compound interest. This is the same amount as the highest Personal Savings Allowance, which applies to basic-rate taxpayers with a regular savings account.

Cash ISAs only become more profitable than a savings account when you maximise the allowance for several years in a row. For most modest savers, this means that opening multiple savings accounts is a more viable strategy to grow their wealth.

Higher rate taxpayers can also grow and protect their wealth by opening multiple savings accounts in the short-to-medium term. While their interest will be subject to tax once it exceeds the Personal Savings Allowance, higher interest rates offered can still make this strategy worthwhile.

Frequently asked questions on the types of ISA and how they work

Can I put £20,000 in an ISA every year?

Yes. The ISA allowance resets every April, as that’s when the new tax year begins in the UK. This means that over time you can build an extremely robust savings portfolio. And the sooner you begin, the greater your rewards.

Once you’ve maxed out your ISA limit, you may want to consider opening high-interest savings accounts to ensure you earn the greatest returns on your cash before the new tax year resets your allowance.

What kind of ISA is best?

Each type of ISA has strengths and weaknesses. The good news is that as of 06 April 2024, you can open multiple ISAs in one year, so you can spread your risk by creating a portfolio of savings options.

Investors with a high tolerance for risk may look to open an IFISA, but the higher rates of interest can require you to use up your entire ISA allowance for the year.

Is an ISA still a good investment?

In many cases, it’s advantageous to open at least some ISAs, though the right mix for you will depend on your circumstances.

ISAs are generally most useful if you’re a higher earner, as it’s likely you won’t qualify for the Personal Savings Allowance. The tax benefits of ISAs are also highest when you maximise contributions over several years.

If your income is under £50,271 per year, the Personal Savings Allowance lets you earn £1,000 in tax-free interest. If you’re a first-time buyer, opening a LISA can help you build a deposit, though restrictions limit the value of the home you can purchase.

Before you make any decisions, consider speaking with a Financial Adviser who can help you assess your options based on your circumstances.

ISA or savings account: which is better?

Whether or not you’re eligible for the Personal Savings Allowance, ISAs can offer alternative ways to reach specific financial goals. But it’s important to bear in mind that ISAs have greater limitations than savings accounts, which can make them less attractive for general saving.

If you’re a higher earner, regularly using the annual limit of £20,000 provides a reliable method of building tax-free savings. This strategy can take time to pay off, so it’s also important to consider the best ways to build your savings portfolio in the short-term to earn as much interest as possible.

Create and manage a high-interest savings portfolio with Flagstone

Build and manage a high-interest savings portfolio with Flagstone. Access 60+ banks with multiple account types in one place, with a single application.

SEE HOW MUCH INTEREST YOUR SAVINGS CAN EARN