What is an ISA?

What You Need to Know

1. ISA's allow you to earn interest on your savings, tax free.
2. There are two main types of ISA, cash and shares based.
3. In both cases you can only pay in a limited amount each year, though the limit is higher for shares based ISAs.
4. The limit on how much you can deposit in an ISA does not take any withdrawals you might make into account, so it can be best no to move money in and out too frequently.
5. Once you have an ISA, you do not have to stay with the same provider. If you're unhappy you can switch for a better interest rate.
6. Historically shares based ISAs have out performed their cash equivalents.

Individual Savings Accounts (ISAs) are essentially a tax-free way of saving money. Your account works in the same way as a normal savings account, except that you won’t have to pay tax on the interest you earn.

There are two types of ISAs; cash ISAs and stocks and shares ISAs. This article will help you to decide if a cash ISA is the right way for you to save.

How much can I save in a cash ISA?

Because the interest you earn on your savings is tax-free in an ISA, the government has set limits on how much money you can invest in each tax year.

In the tax year 2011/12, this was set at £5,340. This means that between 6 April 2011 and 5 April 2012 you could save up to £5,340 in a cash ISA, whether in small deposits over the year or as a single lump sum.

The amount you can invest into a stocks and shares ISA is higher, but these are a little more complicated.

What happens if I take money out of my ISA?

The annual limit on your cash ISA refers to how much you can pay in rather than the actual balance of the account. This means that although you can take money out of your account and put cash back in, you can only deposit a maximum of £5,340 in any tax year.

For example, if you paid £1,340 into your cash ISA in April 2010, then took it out in May, you would still be able to pay in a further £4,000 until the end of the tax year.

But if you paid in your full ISA allowance of £5,100 in April 2010, then took £1,000 out the next month, you would still have used up your year’s allowance – and would have to wait for the new tax year before you could pay any more money into your account.

The new tax year

Each year on 6 April, your tax-free ISA allowance starts all over again – regardless of how much money you’ve got in your account.

So if you already have £3,000 in your ISA from the last tax year, you would be able save another £5,340 when the new tax year starts. If you then use your full allowance, you would have a total of £8,100 – plus any tax-free interest your money has earned.

Again, it’s important to stress the fact that your annual limit refers to the amount of money you can pay in to your account.

So if you have £3,000 from the previous year, and took £1,000 out in May 2010, you would still be able to use your full £5,340 allowance during the current tax year – giving you a total savings amount of £7,100.

Can I switch my cash ISA?

Yes. Many people stick with poor interest rates because they think that switching is too complicated. But switching your ISA can get you a much better return on your savings.

The main thing to remember is that you should arrange the switch with your new ISA provider, who will be able to transfer your savings for you. Don’t simply take the money out to move it yourself – you’ll lose your tax relief if you do this.

How much tax will I save?

The amount of tax you would normally pay on your savings interest depends on how much income tax you pay, explains the government website Directgov.

• If you pay tax at the basic rate, you would usually pay 20% on your savings interest
• If you pay tax at the higher rate, you would usually pay 40% on your savings interest
• If you pay the “saving rate” of tax for savings, you would usually pay 10% on your savings interest.

So by keeping your savings in a cash ISA, you could save 10%, 20% or even 40% on the interest you earn.

Compare ISAs

Savings accounts aren’t all about how much you can earn – you need to think about what kind of saver you are as well. Think about whether you want instant access or an annual interest payment – which could get you a higher rate. You might want to manage your account online or have an ISA at a local bank. These extra benefits are important as often interest rates are fairly uniform across the various UK high street banks.

Cmparing ISAs deals online allows you to look at all the options and find the best possible return on your cash.

Further Reading

• How To Buy and Sell Shares on the Internet
• Common Stock Market Terms Explained
• Find out more on the rules governing ISAs from the government's site.