Think of an ISA as being like a shark cage, with your money floating around inside it completely protected from any encircling tax sharks. So an ISA isn't actually an investment itself, but more of a protective wrapper into which you can put your money.
As long as your money remains in the ISA, then you do not have to pay any tax on it. Once you withdraw it, or if you close the account entirely, then it becomes taxable again. In other words, you want to keep your money inside the shark cage for as long as possible!
This last point is particularly important if you want to move your ISA from one provider to another (to get a higher rate of interest perhaps).
Do not close your original ISA account because, if you do, your money will lose its tax protection. Instead you need to transfer your ISA from one provider to the other. The provider to which you want to transfer will be able to provide information about how to do this.
A little history
ISAs were introduced in 1999, replacing a similar scheme called PEPs that ran from 1987 to 1999.
The rules for ISAs have been changed a number of times since they were first introduced. Some of the changes have made them a little simpler to understand (hurrah!) while others had added a little complication (boo!). And since governments love to tinker with such things, there's no doubt we'll see more rule changes in future.
There are set limits as to how much money you can put into an ISA -- more on these in a minute. These limits apply to each tax year, which runs from 6 April to 5 April the following year.
Stocks and shares ISA
They are two main types of ISA. The first is a stocks and shares ISA.
Everyone aged 18 and above can put up to £10,680 into a stocks and shares ISA for the 2011/12 tax year.
The second type of ISA is a cash ISA. Unlike stocks and shares ISAs, the minimum age limit for cash ISAs is 16.
You can put up to £5,340 into a cash ISA for the 2011/12 tax year.
Cash ISAs are currently the most popular of the two types. 11.3 million cash ISAs were taken out in 2008/09, compared with just 2.9 million of the stocks and shares version. On average people put £2,500 into cash ISAs and £3,250 into the stocks and shares version.
A bit of each?
If you like, you can open both a cash ISA and a stocks and shares ISA in the same tax year. However, the total amount you put in cannot exceed £10,680.
So you could invest £5,340 into each, or you could invest £2,000 in a cash ISA and £8,680 in a stocks and shares ISA. You can't however have £6,000 in a cash ISA and £4,680 in the stocks and shares version, as the cash limit is just £5,340 remember.
You can have both types of ISAs with the same provider, or you can have them with two separate companies. Most ISA providers will also let you combine cash ISAs from previous years into one big cash ISA. The same applies to stocks and shares ISAs.
How the contribution limits work One thing that can cause a little confusion is how the contribution limits work.
The limits apply to all the money you put in during a tax year. So, for example, you can't put £10,680 into a stocks and shares ISA in May, withdraw £2,000 in August and then put it back again in October. In this instance, you used up all of your ISA limit with your initial contribution in May.
Converting cash ISAs into stocks and shares ISAs
One of the new rules added in recent years is that you can decide to convert a cash ISA into a stocks and shares ISA. This allows you to invest in a wider variety of products that should provide a greater return over the long term.
But you can't do the reverse, and convert a stocks and shares ISA into a cash one -- that's not allowed.
Going abroad and death
Generally speaking, you can only put money into an ISA if you're a UK resident. So if you go abroad, you can't put any more money into an ISA. You can keep any existing ISAs that you have though.
As a final note, in more ways than one, once you pop your clogs that's the end of your ISA as well. Any savings or investments you had in them become taxable from the date of your death and they are included in your estate for inheritance tax purposes.
part 2: Cash ISAs (and TESSA-Only ISAs)