Which ISA should I choose for my financial goals?

When individual savings accounts (ISAs) were launched in 1999, there were two types to choose from: Cash and Stocks & Shares.

Since then, the number has swollen to six, with Junior, Lifetime, Innovative Finance, and Help to Buy (this is no longer open to new subscribers) versions all added to the landscape.

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For experienced ISA investors, choosing the right type should be reasonably straightforward. But if you’re new to saving and investing, the process might pose a headache.

So, what plays a part in helping you decide which ISA(s) is right for you? Here are six questions to give you some steer.

1) First, why an ISA rather than other investment products?

Put simply, it’s to do with tax.

You can plough up to £20,000 into ISAs every year, and any growth and interest (including dividends) are sheltered from HMRC; other than fees and charges, you get to keep the lot.

On savings and investments held outside tax wrappers, the taxman could grab up to 20% on gains, 39.35% on dividends, and 45% of your interest.

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What’s more, with most ISAs you can get your hands on the money whenever you like, without penalty. However, some types do charge for early withdrawals so it’s important to understand these before investing.

You’re also not restricted to one type of ISA during the tax year. You could take out one of each, provided you stay within the prescribed annual limits.

And from 6 April, you can choose several of the same type after Jeremy Hunt relaxed the rules at last year’s Autumn Statement.

2) What’s my attitude to investment risk?

Attitude to risk is very much a personal thing. Some of us are natural risk takers, whereas others are more cautious. Most of us are somewhere in the middle.

A simple way to help you decide is to nail down your investment time horizon. Traditional investing wisdom suggests the more time you have, the more risk you can take.

For example, if you need the money in the next two to three years, keeping your money in a Cash ISA, which provides security as opposed to the prospect of high returns, might be your best option.

Stock markets can be volatile over shorter periods, and even well-diversified funds can lose money if share prices tank. The downside with Cash ISAs is that unless the interest you receive outstrips inflation, the value of your pot will erode in “real terms”.

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However, if your goal is more than five years away, a Stocks and Shares ISA might be more suitable, as you have a better chance to grow your wealth. You need to be happy with the value of your ISA moving up and down, and you might get back less than what you put in. But over longer periods you should have ample time to ride out the market highs and lows.

If you opt for a Stocks and Shares ISA, the next step is to consider what to invest in. If you’re a fledgling investor, it can be sensible to keep things simple. Make sure you diversify between different assets and sectors around the globe to spread your investment risk, which you can achieve within a single fund.

The Innovative Finance ISA, which is a tax wrapper for peer-to-peer loans, is also higher up the risk scale. In short, you lend money to individuals and businesses who agree to return your initial investment, plus potentially high rates of interest. The drawback is that borrowers might not repay your capital.

3) Do I plan to use the money to buy my first home?

If your aim is to buy your first home or use the money for your retirement, then a Lifetime ISA (LISA) is worth considering. You can pay up £4,000 into a LISA each year (which counts toward your overall £20,000 allowance) and receive a 25% bonus – up to a maximum of £1,000.

However, there are some strict rules you need to satisfy.

You must be under age 40 to open a LISA, the maximum property value is £450,000, and you can only make contributions until age 50. If you don’t use the money to buy your first home, it’s locked up until age 60 – unless you’re happy to pay a 25% penalty on the full value.

4) Am I investing for me or my children?

A common reason parents save is to give their children a financial head start once they reach adulthood. The spiralling costs of education and housing means outside help has become almost a necessity.

When using ISAs to save for a child’s future, there are a couple of options – either top up your own allowance, or use a Junior ISA.

The latter allows you to save and invest £9,000 a year in your child’s name (which doesn’t count towards your £20,000 allowance) in either cash or stocks and shares, and the money automatically becomes an adult ISA once they turn 18. And provided you can afford to make payments from surplus income, there are no inheritance tax (IHT) implications.

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A Junior ISA may seem the obvious route but there are some things to consider first. The thought of your child receiving a hefty windfall at age 18 to spend as they please may cause some discomfort. You might prefer more control over how and when the money is handed down.

That said, if you plan to use your own ISA, you need to have sufficient allowance spare every tax year.

Whichever route you decide to take, the decision between cash and stocks and shares is again important. As covered in question one, investment time frame plays a major role. Put simply, if your child is more than five years away from their 18th birthday, the stocks and shares version should offer the best chance of growing their pot.

5) Do I have an IHT problem that I’m looking to solve?

ISAs are a wonderful way of shielding your wealth from capital gains tax (CGT), income tax and dividend tax, but usually don’t escape the dreaded IHT.

Therefore, if the value of everything you own is above your IHT-free threshold, HMRC could grab 40% of your ISA portfolio on your death. But there is a solution to this.

Investing in qualifying AIM shares, which you can do within a Stocks and Shares ISA, attracts business relief, which offers 100% exemption from IHT once held for two years.

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Once again, your attitude to risk must be considered. Small, high-growth companies are not for the faint-hearted. You may avoid IHT, but your money will be exposed to significant volatility.

It’s also worth noting that, even if you have an IHT problem, wealth creation rather than preservation may still be your chief objective – especially if you’re decades away from old age.

That doesn’t mean you should rule out investing in AIM shares with at least some of your ISA portfolio; they can be great if you have a large capacity to bear losses and a long investment time horizon. But the IHT-swerving perks might not be as compelling.

6) Should I choose a pension instead?

A bit of a curveball to close, but before topping up your ISA it can be good to pause and consider whether a pension is a better home.

With pensions, you get up-front tax relief on what you pay in – up to a maximum of £60,000, or 100% of earnings if lower – which delivers an immediate 25% boost. Bear in mind that if you’ve already retired or earn more than £260,000, your annual allowance could reduce to £10,000.

If you pay higher rates of tax the attractions of pensions are even greater, as you can claim back an extra 20% or 25% of your annual contributions via self-assessment.

The key factor in the ISA versus pension conundrum is how much access you need. With a pension your money is locked up until age 55 (rising to 57 in 2028). And in most cases, when it’s time to make withdrawals, 75% of your pot will be taxable.

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In contrast, with an ISA you can access the money whenever you like without paying a penny in tax.

If you need some help with this tricky decision, this article might be useful. But the good news is, there’s nothing stopping you from doing both.

One final point: you can change your mind later…

The great thing about ISAs is the flexibility they afford. You can switch between Stocks and Shares and Cash ISAs at any point, which can be handy if your goals shift in the future.