When these tax-free accounts might be useful.

With changes coming to tax-free allowances for investments and interest rates on the rise for savers, you might want to be putting your cash into one of the different ISA types.

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What’s the point of an ISA?

The whole point of an ISA (or Individual Savings Account) is that any money you make from cash within one is tax-free. This continues year after year – once the money is in an ISA it’s protected.

So if you had £5,000 earning 3%, you’d get to keep all of the £150 you’d make, rather than lose 20%, 40% or even 45% to the taxman. The same goes for any dividends issued from investments, or gains (i.e. profit) made from selling shares.

Tax-free sounds good, right? Well, an ISA isn’t the only way to avoid tax on interest earned or gains on investments. There are different allowances on savings, dividends and gains, and you can also save tax-free in Premium Bonds.

These have been enough for most savers and investors in recent years – an ISA just hasn’t been that important. However, things are changing that will impact those allowances.

First though, a quick reminder of the different ISAs and how they work.

What are the different types of ISA?

There are four key ISAs for adults (we’ll ignore the Junior ISA, though you can read about it here).

Cash ISA

The most common ISA, this is one for your cash savings. You’ll get an interest rate, either variable or fixed. You can open one at 16 years old.

Help to Buy ISAs are also Cash ISAs so if you’ve got one (they’re closed to new customers) make sure you don’t also pay into another Cash ISA in the same year unless the product explicitly says you can.

Stocks & Shares ISA

These investment ISAs historically give better returns, though there’s always the chance you’ll end up with less than you first put in. You need to be 18 years old to get one.

Lifetime ISA

This can be either Cash or Stocks & Shares and has its own £4,000 annual limit within the full £20,000. Alongside the interest or investment growth you receive, you’ll also get a 25% bonus on each deposit.

However, the money in a LISA can be used towards your first home or for retirement. If you want to withdraw it for any other reason there’s a 25% penalty, which means you’ll not only lose the bonus, but some of your initial deposit too.

Innovative Finance ISA

These ISAs are for peer-to-peer lending. Your money is at risk here, as with investment ISAs, as the people you lend to via P2P firms could default on the cash.

Pressure on tax-free savings allowances

The Personal Savings Allowance isn’t changing, but a couple of factors could impact when you start paying tax on interest earned outside an ISA.

Higher interest rates

The Personal Savings Allowance allows basic rate taxpayers to earn £1,000 of interest tax-free every year, even if it’s outside of a Cash ISA (in fact earnings from an ISA don’t count towards the PSA). Higher rate taxpayers get £500 a year, while there’s nothing for Additional rate taxpayers.

With low interest rates across the board until recently it’s meant most savers wouldn’t need to bother with an ISA for cash, and instead could focus on the highest paying account.

But now easy-access accounts are past 3% and regular savers hitting 5% to 7%, those with decent yet not massive sums could well breach their allowance.

And if you are fixing for a year or more, you’ll often get all the interest at once when the term ends, rather than monthly.

Take the newly increased NS&I Green Savings Bonds. Saving £8,000 at a rate of 4.2% for three years would mean you get more than £1,000 in one lump sum, using the full allowance. And any extra interest from other accounts will then be subject to tax.

Frozen tax bands

The 20% and 40% tax bands are being frozen until 2028. That means those who are close to those current levels could get pushed into the next tax band with each pay increase or promotion.

And once you earn £50,270 a year you lose half your PSA. Combined with increased interest rates that £500 could be quite easy to fill.

Lower Additional rate tax threshold

This final savings chance won’t affect many people, but from April 6 the income threshold before you pay 45% tax is dropping from £150,000 to £125,140 a year. This means those who earn above this new level will no longer receive a £500 PSA, so they’ll pay 45% tax on all the interest they earn.

Changes to tax-free investing allowances

The tax rates on money you make from investing aren’t changing, but the allowances that give you some tax-free profit outside of an ISA are being cut.

Dividend Allowance cuts

Some shares you’ve invested outside of an ISA might pay out dividends throughout the year, effectively bonus payouts, usually if the company has done well. You’re taxed on this, but receive a Dividend Allowance of £2,000 that is tax-free regardless of your tax rate.

However, this allowance is reducing to £500 over two years as follows:

• April 2023 – cut to £1,000 a year
• April 2024 – cut to £500 a year

If you have a lot of shares that issue dividends, or perhaps you receive them from a limited company, this will mean you’ll be more likely to pay tax at your marginal rate on any dividends paid outside an ISA.

Capital Gains Tax Allowance cuts

Changing over the same period is the tax-free allowance for Capital Gains. Again this is for shares that aren’t in an ISA.

The allowance is currently £12,300, more than enough for most investors who make a profit when selling shares (though obviously you can also make gains on other sales like second properties or expensive art).

The new rates are dramatically lower and will also reduce over two years:

• April 2023 – cut to £6,000 a year
• April 2024 – cut to £3,00 a year

One note here is that you can combine allowances as a couple, effectively doubling how much is tax-free.

The best way to use your ISA allowance

This will obviously vary for everyone as you’ll all have different savings, investments and goals. I’m ignoring Lifetime ISAs here, though they are worth considering in the mix if you are hoping to buy a first home.

It’s worth just remembering that for most people to save or invest £20,000 in a year is quite unlikely. So you’ll probably have enough of your annual allowance to pay into a mix of different ISAs.

If you’ve got investments

If you are an investor, then there’s a chance you’re going to pay more tax over time as your profits grow when that’s outside an ISA.

For new money, it makes sense to put it into a stocks and shares ISA rather than a General Investment Account (GIA) – assuming you aren’t already doing this.

When it comes to existing money saved in a UK GIA you might want to transfer those stocks and shares into an ISA via something called ‘Bed and ISA’. This sells your shares, and buys them again in an ISA, though there could be fees and the value could change while this is happening.

You’ll pay tax on gains outside of the capital gains tax allowance when you do this, so if you have substantial amounts invested, only move over as much as fits within that – though of course you’ll also be restricted to £20,000 each financial year.

If you’re worried about your Personal Savings Allowance

For those earning less than £50,270 a year with a few hundred or a few thousand in savings, even putting them in the highest paying accounts are unlikely to go past their PSA. So you probably don’t need to worry and should just find the best rate out there.

But under these circumstances apply to you, or you think they could, then an ISA might be worth it:

• if you are a higher or additional rate taxpayer
• if you have large sums earning decent interest rates
• if you have a long-term fixed account paying at the end

For these, you need to work out what your real interest rate return will be after tax is deducted outside an ISA to see which one wins.

Remember, you only need to worry about an ISA for interest earned above the PSA, so you can still find the best rate outside an ISA for the first amount of cash. And you can also use Premium Bonds.

If you want to protect against future rule changes

Of course, these are the current rules. If there were to change – perhaps the PSA would be scrapped or the ISA allowance reduced – then there’s a risk that more money outside an ISA would be subject to tax on profits.

So you could lock in as much as you can afford this financial year, protecting that money not just in 2022/23, but each year after.

And even if you’re mainly saving in cash right now, putting it in an ISA now can help you if you want to invest large sums in a few years as you can use it to buy shares in a Stocks and Shares ISA without using any of that year’s allowance.