ISAs: a beginner's guide to understanding ISA accounts

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There are plenty of ways we can think of putting our money to good use; so the fact that we end up handing over an enormous chunk of it to the taxman every year tends to rankle. However, if we thought a little bit more about how we save and invest, we could save an incredible £1.3 billion in tax between us.

And this isn't through complex and controversial tax-avoidance schemes, it's through the government-approved ISAs.

The word itself stands for Individual Savings Accounts. However, it's important not to get bamboozled by the jargon, because essentially an ISA is just a wrapper which gets put around things you already know well - like bank accounts. The product inside is exactly the same - all the wrapper does is save you tax.

ISAs were introduced in 1999, but there's still plenty of confusion surrounding them, so it's worth getting to grips with the basics.

Cash ISA

There are two types of ISA. The first is the most straightforward - the cash ISA. These are exactly the same as savings accounts. However, instead of having to pay your highest rate of tax on the interest (which is 20% for basic rate taxpayers, 40% for higher-rate taxpayers and 45% for additional-rate taxpayers), there's no tax at all on the interest.

Just as with normal savings account, there are a number of varieties to choose from. There is the simple instant-access savings account, there are ones which have fixed rates and you have to save into them for a set period of time, and there are ones where you have to give notice of any withdrawal.

All you need to do is pick the type of account that suits you, search for the best rate, and open an account. You won't have to pay a fee to open a cash ISA.

Stocks and Shares ISA

The second type of ISA is known as a stocks and shares ISA - which is for more long-term investments, and invests in the kind of things which can go up in value - but can also go down.

Instead of investing in cash, these go into a number of things such as shares and bonds (which is where you lend money to a company and they pay you interest).

How you invest in these things is entirely up to you. The simplest way is through a fund: you pay money into the fund, where it is mixed with money from thousands of other investors, and then an expert fund manager will decide the companies they want to invest in.

This has the advantage that you don't have to know which are the best companies to invest in, you just need to decide on the type of fund you want - whether that's one that invests across the world, focuses on specific industries or aims to do something specific - and take a medium-amount of risk. You can then research the most recommended funds in this sector, read the prospectus to ensure it suits you, and invest.

Most people will buy funds through a fund supermarket. They will charge a fee to set an ISA up and invest for you, but it tends to be cheaper than going direct to the fund management company. It's worth checking the fees of a number of these supermarkets before picking the one that's best for you.

If you're more of an expert, you can set up a stocks and shares ISA through a platform, and then use it to invest in a huge range of things, from shares in specific companies, to a whole range of funds and investment trusts.

These aren't entirely tax-free, but there are some tax advantages.

There's no tax on profits. If you invest in shares outside an ISA, you can only make a certain amount of profit in any year before you have to pay tax (£10,900 this year). If you make more than this, basic rate taxpayers pay 18% and higher rate taxpayers 28% in capital gains tax. Inside an ISA there's never any tax on gains, no matter how much you make.

There's also no tax on the interest earned on bonds, and there's a 10% tax on dividends. Basic rate taxpayers only pay 10% on dividends outside an ISA anyway, but higher-rate taxpayers pay 22.5% and additional-rate taxpayers pay 32.5%.

Limits

Every year, starting on 6 April, you get an allowance to invest in ISAs. This year the overall limit is £11,520. If you don't invest during the year your allowance disappears.

The annual limit is worth taking some time to understand. You can invest all of your annual allowance in stocks and shares. Alternatively you can invest up to £5,760 in cash, and the remainder in stocks and shares.

If you use your cash ISA allowance you don't have to use the stocks and shares one too, and you don't have to invest the full £5,760 to take advantage either.

Moving your money

ISAs are not fixed term products, so they will roll on until you take the cash out. As soon as you withdraw anything at all from your ISA, that part of your allowance will disappear.

If you decide to move between savings accounts or funds, it's important not to cash in your existing investment - or your allowance will disappear. You need to contact the provider of your new products and tell them that you want to make a transfer; they will go through the process properly with you.

Once you get your head around ISAs they are nowhere near as complex as they first seem. They're just a great way to save or invest exactly as you would do anyway - but save a fortune in tax while you're at it.

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