How the ISA allowance works
One of the most well-known savings accounts, the Individual Savings Account (ISA) is a popular choice amongst regular savers. In fact, ISAs were designed as a tax-free savings option to encourage people to develop healthier saving habits. Of course, this generous tax break does come with a limit, which is known as the ISA Allowance.
Not sure how it affects you? From how much you can save to the number of accounts you can open, our handy guide explains everything you need to know about the ISA Allowance and how it works.
Why do I pay tax on savings?
Any interest earned on a savings account is considered taxable income. This means we’re all eligible to pay tax on savings interest. However, the good news is the majority of UK savers are unlikely to ever have to pay it. Statistically speaking, less than 5% of the UK population pay tax on their savings due to the Personal Savings Allowance (PSA) and the ISA Allowance.
What is a Personal Savings Allowance?
A Personal Savings Allowance (PSA) is the amount of interest you can earn on your savings before you’re liable to pay tax. Your PSA is dependent on your income. More specifically, the tax bracket you fall into because of your income.
Those paying income tax at the basic rate (20% on your taxable income) can earn up to £1,000 tax-free interest each year. So, anything above that initial £1,000 in the same tax year would be subject to tax.
However, if you’re a higher-rate taxpayer (40%) you have a PSA of £500 a year. This means you can earn £500 a year in savings interest before you’ll need to start paying tax. Those with the highest income tax rate (45%), are not eligible for an allowance.
This does also mean that if you earned a pay rise that pushed you into a higher tax bracket, your savings could suddenly be liable for income tax. It’s also worth remembering that you could reach the allowance threshold sooner than expected if interest rates rise.
Is an ISA Allowance different from a Personal Savings Allowance?
Yes, an ISA allowance is effectively a ‘tax wrapper’ making it separate from the Personal Savings Allowance (PSA). A ‘tax wrapper’ is considered a tax break, which protects your investments by shielding them from tax.
An ISA Allowance works differently from a PSA. Instead of being taxed based on how much interest you’ve earned, an ISA Allowance allows you to save up to £20,000 a year tax-free. Also, as a bonus, your allowance resets to £20,000 each tax year, regardless of how much is already in your account.
What’s more, your ISA Allowance is unaffected by changes in interest rates and does not count towards your PSA. This means you can pay into an ISA without losing your PSA on another type of savings account.
Can I have more than one ISA?
Yes, having more than one ISA is possible. However, there are some limitations that you need to be aware of.
Firstly, you can only fund one ISA account in a tax year. So if you open an ISA after April 2022, then you’ll need to wait until April 2023 to open another.
Secondly, having more than one ISA doesn’t increase your ISA Allowance. Your allowance would still be £20,000 per tax year regardless of the number of accounts you have.
Lastly, you can only add money to one ISA of each type in a tax year. As an example, this means that you can pay into both a Cash ISA and a Stocks and Shares ISA in the same tax year. What you can’t do is add funds into two Cash ISA accounts within the same tax year.
If you have a Lifetime ISA (LISA), the maximum amount you can deposit into your LISA account each year is £4,000. The remaining £16,000 allowance would need to be deposited into a different type of ISA.
What are the different types of ISA?
There are five different types of ISA accounts that you can open – Cash ISA, Stocks and Shares ISA, Lifetime ISA, Innovative Finance ISA and Junior ISA.
Cash ISA
Cash ISAs can be either flexible with easy access or keep your savings locked away over a fixed term. The difference between Cash ISAs and ordinary savings accounts is the tax-free allowance.
Stocks and Shares ISA
Also known as an Investment ISA, a Stocks and Shares ISA enables you to invest in shares, funds, bonds and investment trusts. Remember, you’re not guaranteed to get back what you invest, as investments can fall and rise.
Lifetime ISA
Lifetime ISAs can be used to either buy your first home or save for later life, but not for both. To open one, you must be over 18, but under 40, and can deposit up to £4,000 a year until you’re 50. You’ll also receive a 25% government bonus on your savings, up to a maximum of £1,000 per year.
Innovative Finance ISA
With an Innovative Finance ISA (IFISA), you can invest in peer-to-peer (P2P) lending investments using your tax-free allowance. P2P lending is when you lend money to borrowers and businesses, who then pay it back with interest on top.
Junior ISA
Junior ISAs can be set up by a parent or guardian on behalf of a child, as a way to save specifically for their child’s future. Once the child turns 18, the savings would usually be transferred into a Cash ISA.
Does withdrawing money affect my ISA allowance?
If your ISA is flexible, you can withdraw funds at any time. In most cases, funds taken out of a Cash ISA, a Lifetime ISA or a Stocks and Shares ISA are not taxable. In fact, with our Cash ISAs, you can take money out and put it back in during the same tax year, without losing any tax benefits.
However, if you have savings tucked away in a Fixed Rate ISA, you could be liable for an early access charge if you make a withdrawal during the fixed term. If you’re unsure, please check the terms of your account before withdrawing funds.
It’s also important to note that ISA transfers don’t affect your ISA Allowance. Providing that you use the official transfer form, transferring your savings from one provider to another will not impact your allowance.
What about Junior ISAs?
Junior ISAs have their own ISA Allowance of £9,000 per tax year. This means that parents and guardians can pay into a Junior ISA without it coming out of their own ISA Allowance. Once the child turns 18, the Junior ISA account will be changed into an adult ISA, making them eligible for the £20,000 ISA Allowance.
What happens if I exceed my ISA Allowance?
If you’re paying into different ISA accounts, then it’s possible to accidentally exceed your limit. If this happens, avoid trying to fix it yourself by withdrawing funds. Instead, get in touch with HMRC who will advise you how to correct the mistake.
