ISA masterclass #2: What can you put into an ISA?

SavingsWe know what an ISA is, but what investments can you put into one?

Each day this week we're taking a closer look at the Fool's favourite tax-efficient savings scheme. Join us for our ISA masterclass!

Last time we looked at what ISAs are, and at the current allowances. We saw that an ISA is really just a tax-free wrapper than you can use to avoid paying tax on investments, and that you can presently invest up to £10,680 a year within such shelters.

Today we'll take a look at what kinds of investments you can hold within an ISA. In the past, ISA rules were more complex, but today there are only two types of ISA.

Cash ISA
A cash ISA is the simplest kind, and they're offered by all the high street banks -- you've almost certainly seen them being advertised.

The most popular work just like instant-access savings accounts, in that you can pay money in and take money out any time you want (with the restriction that you can't take money out and put it back in again if that would take you over your annual contribution limit).

There are several variations on the theme, too. If, for example, you don't want instant access, you can often enjoy a better interest rate, with some providers offering fixed rates for fixed periods (just like the range of ordinary savings accounts available).

Stocks and shares ISA
The other kind of ISA is a stocks and shares ISA, and as the name suggests, this is the kind to use to protect stock-market investments from tax.

A fairly wide spread of investments can be included in a stocks and shares ISA, including individual shares, and a range of pooled investment funds such as unit trusts, investment trusts and bond funds. One favourite investment here at the Motley Fool is a low-cost index-tracking fund, which we see as a great investment to tuck away for the long term.

One important restriction is that shares traded on the Alternative Investment Market (AIM) cannot be held in an ISA. Many people think the rule is silly, because it precludes investment in some faster-growing companies, but that's just the way things are. (Note that a few AIM shares can be held in an ISA, but only if they are also traded on a major stock exchange elsewhere.)

Stocks and shares ISAs are usually operated by stockbrokers, and most companies that offer online share dealing will also offer an ISA -- it is run just like a normal online broker's account, except that you don't have to declare any capital growth and dividend income generated within the ISA to the tax man. That said, any cash held within a stocks and shares ISA does attract interest with 20% tax automatically deducted, but such interest does not have to be declared to the tax man either.

Mix and match
Do you have to choose one or the other? No, you can mix and match however you like, providing your cash ISA portion does not exceed £5,340 (at least during the current tax year). So you could go for anything between a 50/50 split with £5,340 in each, or putting the whole £10,680 in a stocks and shares ISA.

What's next?
If you have any questions on what we've covered today, just ask in the Comments section below and we'll do what we can to help. Next time we'll take a look at how ISA tax benefits work.