Socking away a little extra money is never a bad idea. How one goes about that, however, can make all the difference in terms of actual money in hand for a rainy day. There is a myriad of traditional and non-traditional options, from regular interest-based savings accounts to investment portfolios and even exotic derivative funds.
However, most of these options involve reporting a certain percentage of your saved earnings interest as taxable income. This can greatly eat away at the overall benefits of setting money aside, particularly for those who anticipate large sums of earned savings interest. As such, there is a good deal of interest in identifying options that are as tax-efficient as possible.
To that end, United Kingdom residents should consider opening a cash individual savings account, or cash ISA. These financial tools basically are ordinary savings accounts with the important caveat that interest earned in these accounts can be held tax-free. We are going to walk through some of the basics of what ISAs are, why you need one, and how you should go about setting one up for yourself.
Am I Eligible to Open a Cash ISA?
First things first – are you eligible to open a tax-free cash ISA? The requirements look simple at first glance, but it is worth noting a few technical details that will make your saving more efficient.
You must first be a resident of the United Kingdom and above 16 years of age. This does not necessarily mean that you need to be a passport-carrying UK citizen, but you must be legally considered a resident for tax evaluation purposes.
You must also be starting the cash ISA process for the first time this tax year. That is, you cannot open a new cash ISA if you have already opened one so far this tax year.
The “individual” in individual savings account really ought to clue you in to one of the big benefits of opening one. Since it is tied to you, personally, each eligible person in your household can open their own. This can be useful in a variety of situations. A husband and wife can each open their own cash ISA, allowing them a bit of a loophole for getting around the legal cash ISA limits (more on that later). Furthermore, each eligible child in such a household can hold their own cash ISA in their own name.
Just a brief aside for U.S. readers – there is no one-for-one equivalent within U.S. tax law for the UK’s ISA system. The closest comparable account would be Roth individual retirement accounts, or IRAs. The crucial difference between an ISA and an IRA is that IRAs typically carry heavy restrictions and/or penalties on how much money can be withdrawn from the account – and at what time. As the name suggests, an IRA is designed to be paid into and withdrawn for retirement spending after the age of 65, whereas an ISA is far more flexible and can be used for any purposes, up to and including retirement.
Now that we have established who can get a cash ISA, we will look at some of the reasons you might consider opening one today.
Different Types of ISAs
One of the first wrinkles you are going to encounter is that there are four different kinds of ISAs, with cash being just one flavour.
Stock and share ISAs are a tax-efficient investment instrument, while innovative finance ISAs are really peer-to-peer lending tools with certain tax advantages. Finally, lifetime ISAs can be divided up into tax-free savings plans or tax-efficient investment plans.
Cash ISAs are a bit of a different animal, being solely a savings vehicle as opposed to an investment. Cash ISAs themselves can be split into two main varieties. The most common one features variable interest rates, which means that the interest rate may change over time. Some ISAs come with fixed interest rates, similar to savings bonds. The significant difference between the two for the average cash ISA user is that variable interest rate ISAs generally do not institute penalties for withdrawing money from the account. Fixed-rate ISAs, however, generally do charge early withdrawal fees to recoup money that would otherwise have been gained by raising interest rates.
So, why get a cash ISA in the first place? The ability to save without paying additional taxes is the most obvious benefit, but this means far more than just additional money in the bank. Money saved via an ISA is tax-free forever, shielding it from various interest-based tax regulations that kick in at certain saved cash levels. Overall, depending on your particular tax bracket, you could save up to 45 per cent of your earned interest that would ordinarily go to tax payments.
How Much can I Save in a Cash ISA?
There are a few caveats to opening and maintaining a cash ISA that you should be aware of when considering all your savings options. While useful for limiting tax obligations, cash ISAs necessarily have certain financial limits. This is to be expected; otherwise, there would be no reason for traditional savings options whatsoever.
For the UK tax year – 6 April to 5 April of the subsequent year – an individual may only put up to £20,000 into a cash ISA. This is an all-in amount for all varieties of ISAs; if you choose to put the maximum into a cash ISA, then there will be no wiggle room left over for stocks and shares ISAs, lifetime ISAs, etcetera. It works in reverse, too. If you already have funds tied up in one of the other forms of ISA, you are still limited by the maximum fund cap should you choose to open a new cash ISA.
It is important to note that tax-free funds in a cash ISA are additive to the UK’s personal savings allowance, or PSA. Originally instituted on 6 April, 2016, the PSA system permits taxpayers to put away up to £1,000 in savings interest per year tax-free, provided they make the basic rate taxpayer requirement of earning less than £45,000 per year. Taxpayers with higher annual incomes – meaning a 40 per cent tax bracket between £45,001 and £150,000 in earnings – are limited to PSA savings of just £500 per year.
Obtaining a Cash ISA
Cash ISAs are a financial product like any other, and that means that they are offered by a variety of institutions with a rainbow of options, fees, and interest rates attached.
The process of obtaining a cash ISA begins with a hefty amount of homework. Begin with an online search for cash ISA providers – generally banks or other financial instrument providers. Be sure to read the fine print regarding interest rates. It can pay immense dividends – literally – to shop around so that your money can earn the highest interest rate possible.
Once you have found a favourable provider, it is time to decide which cash ISA fits your predicted savings style. Remember that there are two main varieties – variable and fixed. If you plan to withdraw from your savings on a semi-regular basis, it probably makes the most sense to go with a variable cash ISA to avoid the withdrawal penalties attached to fixed-rate plans.
Funding your cash ISA will differ from provider to provider, but it will generally involve the use of either a bank account linked to the cash ISA provider or a valid debit card; few options exist for funding cash ISAs with credit cards, and that is just as well since you would be negating your interest savings with the interest accrued on the borrowed credit card funds.
Getting Your Money
We have gone through the basics of what cash ISAs are, why they are a valid savings option, and how to go about obtaining one. Assuming you have made it this far along in the process, it is time for the rubber to really meet the road. You have a cash ISA, but an unexpected expense has come up. How do you go about withdrawing your funds?
So-called easy-access ISAs permit you to withdraw your money with no restrictions on time and no additional cost. This usually comes at the expense of less favourable interest rates. Withdrawing funds from a fixed-rate ISA is more complicated, and users who do so will likely incur a penalty that varies from provider to provider. It is helpful to think of these ISAs as bonds, with term limits ranging from one to five years. Withdrawing funds before the “maturation” of the ISA will trigger a fee to cover the loss of interest revenue for the provider.
There is a loophole when it comes to withdrawing funds that can make managing your cash ISA funds a tad easier, assuming your provider gives you the choice to open a flexible ISA. As of the new ISA rules introduced in 2016, money withdrawn from an ISA can be paid back without affecting the annual ISA total cash allowance. Basically, the money that is withdrawn from the ISA is considered, legally, to have never been entered in the first place. Removing £500 from your ISA and then paying it back does not, in other words, count as a total payment of £1,000.
Transferring Funds Between ISAs
While opening, funding, and withdrawing funds from a cash ISA can be relatively straightforward, it pays to know some of the auxiliary rules regarding more exotic scenarios, like transferring money from an ISA to a different financial instrument or inheriting ISA funds.
Should you decide to shift funds from on cash ISA to one with a more favourable interest rate, do not fall into the trap of first withdrawing the funds and then putting them into the new account as if they were your initial savings. By withdrawing the funds in the first place, you void the tax-free status they had while they were safely locked in the ISA. Instead, check with your provider regarding its ISA transfer procedure. This ensures that the money never leaves the ISA system and so does not become a target for tax obligations.
Just a few points here. Not all cash ISA providers will allow you to transfer funds into their cash ISA from another provider. Moreover, you will likely incur fees as a result of moving your funds from one provider to another, so be sure that the new interest rate more than makes up for the cost of shuttling money around. Finally, the “one year, one cash ISA” rule still applies here. You will not be able to jump ship from your established cash ISA to a newly opened one if you initiated both processes during the same April-April tax year.
Finally, what should you do if you stand to inherit or pass on funds locked up in an ISA? UK law allows for survivors to inherit ISA funds while retaining the tax-free benefits that the fund accrued over time. This takes the form of a one-time ISA allowance in the value of the deceased’s total ISA holdings. The holdings can then be put into a new ISA taken out by the survivor. Crucially, this is an exception to the once-a-year rule – in this instance, the survivor may open a second cash ISA in the same tax year to rehome the inherited funds. Inheritance taxes will still apply in all cases but those involving spouses or civil partners.
Plan for the Future
Cash ISAs are a great way for of-age UK residents to store a little extra money and make some tax-free earned interest. There are limits to this method, however, involving age, legal residency, and exactly how much can be put away in a single tax year. Knowing your provider’s fee schedule and what kind of cash ISA services it offers is crucial, and different savings strategies may require different providers. Should a better opportunity arise, it is a relatively simple process to shunt funds from one cash ISA to another – provided you have already done your homework, have ensured that both providers have modest fee schedules, and are not trying to make a transfer in the same tax year as opening your initial cash ISA. Should you come into inherited cash ISA funds, the rules shift just a little – a new cash ISA can be opened and the money rehomed without losing its tax-free benefits.