Cash ISAs
A cash ISA is a savings account that is tax-exempt up to maximum annual investment level. Cash ISAs are available from banks, building societies and other providers such as National Savings & Investments (NS&I). £5,200 may be put in a cash ISA for the current financial year (10/11). This new limit applicable to everyone for the 2010/2011 tax year. In 2009/2010 this limit was only available to those aged over 50.
It is best to think of a cash ISA as a normal savings account. Money is added to the account (up to the current limits), and interest is earnt - which isn't taxed. Usually, tax would be levied on savings interest at 20%, or 40% for higher tax payers. Everyone receives a new ISA allowance each year, so it is possible to amass a large tax-free sum.
You are only permitted one cash ISA account a year, so it is not possible to divide your yearly allowance across accounts. However, ISA accounts from different years can be kept separately. The ISA rules do not stipulate that money must be held for any amount of time. However, if cash is withdrawn, then it cannot be replaced and the tax benefits are lost. Cash ISAs are particularly beneficial if held with a long term view. If the interest is paid directly into the cash ISA, then the interest will compound. For example, a £5,200 cash ISA paying 5% will pay about £260 in the first year. However, after forty years it will have earnt about £31,400 in interest alone! This is because interest is paid on the interest, which results in a larger payout each year.
There are three types of cash ISA accounts; variable rates, fixed rates, and regular savers. The variable rate ISA will pay a non-fixed amount of interest - so the provider may lower (or increase) the rate of interest. Variable accounts are usually instant access, so there are no penalties for withdrawals, or it is possible to transfer the ISA if the interest rate is uncompetitive. It is also possible to add funds throughout the year, up to the yearly allowance.
A fixed rate ISA will pay a set amount of interest for a defined period. This might be a year, or even up to five years. The rate of interest offered will usually be higher than a variable rate account, but there will usually be penalties (i.e. loss of interest) if you want to make a withdrawal, or a transfer before the maturity date. However, some accounts occasionally offer a fixed rate with no such penalties - but as always, be careful to check the account details. It is usually not possible to add additional funds to a fixed rate ISA after the initial deposit. So if the account is opened with £1,000, the rest of your cash ISA allowance in that year would effectively be lost.
Regular savers allow you to add to your ISA on a monthly basis, and often offer competitive interest rates that are fixed for the year. However, ensure that it will be possible to use your full ISA allowance - if the account has a maximum payment permitted per month then it might not be possible to utilise the full allowance by the end of the tax year (especially if starting several months into the year).
In addition to the annual allowance of £5,200 in cash ISA savings, you may also opt to save a further £5,200 in an equity ISA (also known as a 'stocks and shares ISA').