What are ISAs?

Hi, my name is Damian Faye and I am the founder of the personal finance website Money to the Masses. In this video I'm going to be talking about tax-free saving and in particular how ISAs are a good way to save and invest without having to pay tax on the proceeds.

Whether you earn an income from employment or investments the money is likely to be subject to income tax. The good news is that everyone has a certain level of income they can earn without being charged income tax and that's known as their personal allowance.

For the 2021-2022 tax year the personal allowance is £12,570. Anything over this amount can ultimately be subject to between 20% and 45% income tax, depending on how much you earn. If you generate an income from interest on your savings then you can also make use of the personal savings allowance which is set at £1,000 for a basic rate taxpayer. This means you can earn up to £1,000 a year in interest on your savings without having to pay tax on it. The allowance is reduced to £500 for higher rate taxpayers and is reduced to zero for those earners that are in the highest tax bracket known as the additional rate.

Most people use their personal allowance up via their employment income. That means that if you have significant savings or investments that generate income you could lose a sizeable portion to taxation. On top of that if you invest in shares, for example, any profits you make when you sell them are potentially subject to capital gains tax as well. Again, each person has a tax free allowance for capital gains, but this is limited to £12,300 pounds a year. The problem is that as your investments grow over time your returns will be subject to more and more taxation or - in other words - unless you are prudent HMRC can take a significant chunk of your savings and investments.

The good news is that you can shield your savings and investments from HMRC and taxation by using an Individual Savings Account also known as an ISA. The two main types of ISA are Cash ISAs and Stocks and Shares ISAs.

A Cash ISA is essentially a savings account that does not require you to pay tax on your interest that you earn, no matter how much. This is more suited to those who are risk averse.

A Stocks and Shares ISA - also known as an Investment ISA - is a tax efficient investment account that is more suitable for those aiming to grow their wealth in excess of inflation over time, and who do not need access to the money for at least a five year period. The money in your ISA can be invested in a range of assets including shares and bonds.

Investment ISAs are not without risk and their value can fall as well as go up, unlike a Cash ISA. Because of the tax benefits of an ISA you can only pay in a maximum of £20,000 per person per tax year, split across a Cash ISA and a Stocks and Shares ISA. The tax savings of using an ISA can be significant because if you are a basic rate taxpayer and invest £200 a month in a Stocks & Shares ISA, then after 10 years you would have a total of £29,508 pounds, assuming the investments grow at an average rate of 5% a year. That is more than £5,058 profit which is totally tax-free, saving you more than £443 pounds in tax assuming an equal split of income and capital growth.

If you're a higher rate income taxpayer that jumps to £1,328 pounds. The more you invest the greater the potential tax savings. That is why ISAs are a key part of any financial plan that is investing for the future.