ISAs are a great way to build up tax-free savings. But many investors are unsure about the differences between cash ISAs and stocks and shares ISAs.
Today I want to explain why you can have both types of ISA, but why the stock market variety is likely to be a more effective way to build wealth.
What’s so good about ISAs?
Everyone aged 16 and over can put £20,000 into an ISA each year. These accounts are tax free, so you’ll never have to pay tax on interest, income or capital gains earned on this money.
As the name suggests, you can only put cash into a cash ISA. This money is protected by the Financial Services Compensation Scheme (FSCS) up to a maximum of £85,000.
However, the tax savings in cash ISAs are often fairly modest. At the time of writing, the best interest rate on an easy access cash ISA was about 1.45%. At that rate, you’d need £68,965 in your ISA to receive interest of £1,000 in a year.
However, the government’s personal savings allowance means that even in a taxable savings account, basic rate tax payers can earn up to £1,000 of interest tax-free each year. So unless you have a lot of cash saved, cash ISAs provided limited tax benefits at the moment.
Cash vs stocks and shares
Stocks and shares ISAs offer the same tax-free protection as cash ISAs, but because they’re investment accounts, the value of your money can rise and fall. Because of this, these accounts should be used for long-term investment only, in my view.
The real attraction of stocks and shares ISAs is that the tax benefits are potentially much greater. At the time of writing, the FTSE 100 offers a dividend yield of 4.4%. With the £68,965 I mentioned above, you could generate a cash income of about £2,750 each year.
That’s worth sheltering from tax. And over the long term, history suggests you would enjoy capital gains on top of your dividend income. The long-term average return from the UK stock market is about 8% each year. At this rate, the tax savings with a stocks and shares ISA could really mount up.
The good news is that you don’t have to choose between a cash ISA and a stocks and shares ISA. You can pay into one account of each type every year, as long as your combined payments don’t exceed the £20,000 limit.
Getting started with a stocks and shares ISA
A stocks and shares ISA is like a wrapper. You can put investments such shares, funds or government bonds inside the ISA, and any future returns they provide will be tax free.
I think the best way to get started is to open a stocks and shares ISA and then put a FTSE 100 tracker fund into it. Many allow you to save as little as £25 per month, so you don’t need a lot of spare cash to get started.
Tracker funds are also usually the cheapest funds you can find, which is good news. Low fees mean you keep more of the profits.
As with all investing, the most important thing is to start as early as you can, so that your money has more time to work for you.