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Easy Guide to ISAs

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At the beginning of every tax year, many of us promise ourselves that this will be the year that we get organised when it comes to our accounts; that we'll finally invest, budget and save for the future. However, it’s easy to get lost in financial jargon and all-intimidating banking vernacular.

However, the new tax year is the perfect time to make use of one of saving's most useful tools, namely the Individual Savings Account, or ISA. Whilst you'll no doubt be familiar with the phrase, understanding just what they are, how they work and how to go about finding the best one for you can be a confusing business, and so we asked moneysavingexpert.com’s web editor, Dan Plant, for a simple guide to ISAs. Here's Dan's top tips for choosing the right investment:

ISAs – the basics

ISAs are simply a way to invest your money without having to pay tax on any interest that you earn, unlike a normal savings account where most people hand over 20% of the return on their savings to the taxman (and 40% for higher earners). Savers can contribute up to a limit within any given tax year (6 April – 5 April the following year), which makes now the perfect time to invest.

Cash ISAs vs. Stocks and Shares ISAs

According to Dan, a Cash ISA is the simplest form of ISA, and is simply a savings account. Every UK adult aged 16 and over is allowed to save £5,340 in a Cash ISA this tax year (2011-12). As the interest isn’t taxed, the return on your money is usually higher than what you would earn in a standard savings account. However, Dan warns against signing up to the first Cash ISA you see, as rates can vary massively. For example, Dan points out that you can currently get up to 3.3% AER interest with Santander’s Flexible Cash ISA, and you can access the money at any time.

If you’re feeling more adventurous with your money, the alternative option is a Stocks and Shares ISA. Available to all over 18s, this type of ISA is an investment as opposed to a straightforward savings account. Instead of return being set by a simple interest rate, investors must choose stocks or shares for their money to be invested in, and their performance affects the return. Dan says it’s important to note that you could end up losing money with this type of ISA, although the potential gains are higher than with a Cash ISA, and returns are still free of tax. This tax year you get an overall ISA allowance of £10,680, of which up to £5,340 can be saved in a Cash ISA (as detailed above). Whatever amount you don’t use as cash can be invested in stocks and shares instead. For example, if you put £2,680 in a Cash ISA you’ll have £8,000 left to put in a Stocks and Shares ISA.

How to invest

The first thing to do is to work out how much you can save on a regular (for example, monthly) basis. Whilst this can be no doubt difficult with beautiful bags to distract us, the key here is discipline. Dan suggests taking a thorough look at all your income and outgoings (“from cappuccinos to Christmas”) to work out how much you can spare each month. If you need help with this, try out moneysavingexpert.com’s free Budget Brain tool. Once you know how much you can commit to saving, set up a standing order to move that amount to your ISA each month – just like a direct debit to pay your bills, only you’re paying into your savings instead.

Alternatively, if you have a large amount of cash (whether you’ve had a cash windfall or have a significant amount already saved), you can invest this as a lump sum too.

More useful tips

Dan says that anyone who has saved in an ISA in the past should also use the new tax year as a reminder to check what interest rate they are earning on existing savings – often banks slash rates down to nearly nothing when they think you’re not looking. However, many top-paying ISAs allow transfers in, which let you switch providers to increase the rate you earn on your cash.

But Dan warns to never just withdraw your ISA savings and move them yourself. Call the new bank and arrange the transfer through it, as there are complex rules that must be followed in order to protect your money’s tax-free status.

Picture credit: Rex Features

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