Building a nest egg is crucial for a secure financial future.

Choosing the right home for your money will help boost your savings, and individual savings accounts (ISAs) can be a smart way to save because of their tax benefits.

Here, we explain everything you need to know about ISAs and why you may want to consider them as a home for your hard-earned money.

What is an ISA?

An ISA isn’t an investment itself. It’s simply a tax-efficient wrapper that you can hold savings or investments in, which in effect shields your returns from the taxman.

The main benefit of ISAs is that any gains made are tax-free and you don’t even have to declare your ISA savings and investments on your tax return.

You can only pay a certain amount into ISAs each tax year. The ISA limit for the current 2023/24 tax year stands at £20,000. You get a new ISA allowance at the beginning of each new tax year starting on April 6, so if you can afford to put money away every year, you can create quite a significant tax-free savings pot over time. It’s a case of use it or lose it with your ISA allowance. Any part of your allowance you haven’t used by the end of the tax year cannot get carried over into the next tax year.

Some ISAs allow you to withdraw cash and then replace it within the same tax year, without this affecting your tax-free allowance. For example, if you pay in £20,000 and withdraw £1,000, you may be able to replace the £1,000 as long as you do so in the same tax year as you made the withdrawal. ISAs that allow you to do this are called flexible ISAs but not all offer this flexibility so always check first that your provider will allow you to do this.

Different types of ISA

You can use your annual Isa allowance to invest in one specific type of ISA or across the several types of ISAs available.

The right type of ISA for you depends on your circumstances, attitude to risk and your age.

Cash ISAs

A cash ISA is a simple tax-efficient savings account in which money can be held. You can hold money in a cash Isa with a bank or building society, with most offering a range of accounts including easy access cash ISAs and fixed rate cash ISAs.

Easy access cash ISAs allow you to make withdrawals whenever you want, whereas fixed rate ISAs often pay slightly higher rates of interest if you are happy to lock your money away for a set period of time. Early withdrawal can come with interest penalties, so make sure you’re selective with the period you choose. Despite the current low rates available, cash ISAs remain the most popular choice for savers.

You can find current best buy cash ISA rates in our article Best cash ISA rates – which cash ISAs pay the most interest? which is updated weekly, or find out more about cash ISAs in our article How cash ISAs work.

Tax benefits: Interest paid on cash ISAs is tax-free and doesn’t count towards your personal savings allowance either.

This allowance enables basic rate taxpayers to earn up to £1,000 of savings interest a year in a non-ISA savings account tax-free, while higher rate taxpayers can earn up to £500 tax-free. Additional rate taxpayers who pay tax at 45% don’t get a personal savings allowance.

Bear in mind that because of the tax incentives cash ISAs often pay lower rates of interest than normal savings accounts. This means that depending on your tax rate and personal savings allowance eligibility you may actually be better off not using a cash ISA.

However, for those with a lot of savings or who have already used up their personal savings allowance, or who think they may exceed it in future, cash ISAs are still very worthwhile.

Stocks and shares ISAs

With a stocks and shares ISA, sometimes known as an investment ISA, you can put your money into a wide range of investments including collective investment funds, Exchange Traded Funds (ETFs), investment trusts, gilts and bonds and of course, stocks and shares.

This means taking on more risk as the value of investments can go down as well as up, but over long time periods, stock market gains typically outweigh those achieved by cash accounts.

Most people starting out with stocks and shares ISAs tend to choose investment funds, where your money is pooled with that of other savers and invested by a fund manager.

It can be a good way to spread the risk of investing as if one or more companies you invest in fail, there is a chance that gains from other companies in the fund may more than offset these losses.

If you’re looking to invest in an ISA, fund platforms such as Fidelity, Hargreaves Lansdown and AJ Bell can help narrow down your choices with recommended fund lists, which might highlight 50 funds out of the 3,000 plus available to UK savers. They also offer ready-made funds for a range of different risk profiles if you don’t want to pick investments yourself. Bear in mind that there are charges associated with stocks and shares ISAs and you’ll pay a fee to the platform as well as for the funds held.

Tax benefits: Stocks and shares ISAs are a good way to invest in the stock market without having to worry about paying capital gains tax or income tax on your returns. There are two ways in which investments can create a return, capital gains (when the value of your investments goes up) and dividends,which are essentially a share of the companies’ profits. When these investments are held inside an ISA, you don’t pay tax on any capital gains you make or on any dividends you receive.

Some people might be put off investing by the complexity of managing the tax situation, but the fact that you don’t have to declare investments in an ISA on your tax return can make them a very simple way to get started with investing. 

Innovative Finance ISAs

The Innovative Finance ISA (IFISA) was launched in 2016, allowing savers to earn returns by making loans through peer-to-peer lenders. Since then more than £588 million of savings has already been stashed into Innovative Finance ISAs, according to trade body the Peer-to-Peer Finance Association.

This type of ISA matches up people who have money they’re willing to lend with borrowers who perhaps need a loan to pay for a new car, holiday or home improvements, or to fledgling businesses needing cash to expand their operations or purchase equipment.

Other types of peer-to-peer investments allow investors to lend their cash to specific types of project that pay much higher rates. For example, some platforms lending to commercial and residential building projects and others into renewable energy projects claim they offer double digit returns in some cases.

However, while the returns offered can appear very attractive, these are not guaranteed and there are several big risks to consider.

First, there is a danger that the business, individual or project you lend to cannot meet their repayments. Many peer-to-peer lending sites have contingency funds, which are designed to protect investors if this happens, but it’s well worth checking exactly where you might stand if a borrower does default on their payments.

It’s worth noting too that the Financial Services Compensation Scheme (FSCS), which pays savers up to £85,000 if a savings provider goes bust, doesn’t protect peer-to-peer investors in the same way.

This means that investors could potentially lose everything – and some already have with several peer-to-peer firms going bust in the last year.

There is a simple rule in investing, that the higher the return offered, the higher the risk you’re taking with your money. Because peer to peer lending is expressed as a % return, many ordinary investors have plowed money into them thinking they are as safe as a savings account. The reality is that those that are paying high rates of interest, do so to encourage investors to invest, but there is a real risk that you could lose your money.

Doing your homework and finding out what individual firms offer if something does go wrong is crucial. Experts generally suggest only holding a small amount of your savings and investments in this type of ISA, because of the risks involved. You can learn more about how peer-to-peer lending works in our guide Peer-to-peer lending – is it a good investment?

Lifetime ISAs

The Lifetime ISA is exclusively for people aged between 18 and 40, so might be of interest to your children or grandchildren. For every £1 saved into the account, the Government will contribute another 25p tax-free. So, based on a maximum £4,000 a year contribution, the tax-free bonus will be £1,000.

This money can be put towards buying a first home worth up to £450,000, or to save for retirement in a similar way to a pension. Money still in the account at the age of 60 can be used to boost your income when you stop work.

If you withdraw the money for any other reason you’ll pay a 25% exit penalty.

Like regular ISAs, the lifetime ISA is available as a cash ISA or a stocks and shares ISA however, very few providers offer the cash versions – there are currently just five and all but one are building societies. The £4,000 annual limit counts as part of your overall £20,000 annual ISA allowance.

Junior ISAs

Parents and grandparents can also invest in a Junior ISA, designed for under 18s. The rules allow you to shelter £9,000 in the current tax year in either cash or stocks and shares.

Money held in a Junior ISA can’t be accessed until the child reaches the age of 18, at which point they can add to or withdraw from it as they would with any other ISA. They can start managing the account on their own from the age of 16, so this may not be the right option for you if you want to retain control of their cash.

Those aged 16 or 17 can have a Junior ISA allowance plus a cash Isa allowance. You can find out more about Junior ISAs and other types of financial gifts parents and grandparents can make in our guide Financial gifts for young children: what are the options?

How do I open an ISA?

Whichever kind of ISA you choose, most providers allow you to open an account online.

You’ll need your National Insurance number to hand, as well as your bank details.

You may be asked for various forms of identification, depending on the provider. For Junior ISAs, the parent will need their own National Insurance number and basic personal details such as name and address and will be asked to confirm they are the child’s parent or guardian. They will also need the child’s name and birth certificate – and their National Insurance number if they are aged 16 or over.

If choosing your own investments feels too daunting then you can enlist the help of a professional financial adviser who can recommend which ones are right for you based on your investment timeframe and your approach to risk. You can find a local financial advisor on VouchedFor or Unbiased, or for more information, read our guide on How to find the right financial advisor for you. VouchedFor also offer a Free Financial Health Check with a trusted, well-rated advisor in your local area so you can see if you think advice might be for you.

You can also learn more about investing in our article Investing – the basics.

Switching ISA providers

ISAs are set up to allow you to easily transfer between providers, and between different types of ISA, so cash to stocks and shares and vice versa.

However, not all ISA providers allow transfers, so you’ll need to check with the individual providers you want to move from and to.

Crucially, if you do want to transfer to a different type of ISA, never withdraw the cash from your ISA and move the money yourself. This means it will lose its tax-free status. The correct method is to contact the provider you’re moving to and ask them to make the transfer. There’s a very simple transfer form to fill out, the rest is done on your behalf by the provider you’re moving to.

ISAs and inheritance

An ISA can be transferred to a surviving spouse while retaining its tax-free status. No more money can be added to the ISA after the death of the original owner, but any growth in value during the probate stage will be tax-free.

If it is passed to your spouse, they will get an additional ISA allowance equal to the value of the cash or investments passed on, or the value of the ISA on the date of death, whichever is higher.

If it is being passed to anyone other than your spouse, it may be subject to inheritance tax (IHT). This is payable at a rate of 40% on the value of the overall estate which is above the current £325,000 IHT allowance. You can find out more about how inheritance tax works in our article Understanding Inheritance Tax.

Inheritance tax ISAs

For those with a stocks and shares ISA, it’s worth knowing that many stocks listed on the Alternative Investment Market (AIM) – which is mostly made up of smaller companies – are exempt from IHT if they’ve been held for more than two years. This is because they qualify from what is known as Business Property Relief.

There are a number of more detailed requirements for AIM shares to be eligible, for example they have to be trading companies, the shares need to be held directly rather than through a fund and they can’t have a dual listing on another stock exchange. It’s a complex area and not without risk, especially as it involves investing in smaller companies and tax rules can change down the line so it’s important to seek professional advice and only use a reputable provider if it’s something you are considering.