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How does the Isa allowance actually work?

You’ve got one month left to make the most of your Isa allowance before the 2018-19 tax year starts on 6 April. Find out how.

How does the Isa allowance actually work?

The end of the 2017-18 tax year is fast approaching, marking the perfect time to make sure you make the most of your £20,000 Isa allowance.

You can also start planning how to best use your Isa allowance for the 2018-19 tax year, which will remain at £20,000.

Find out how different types of Isas work, how transferring between them can affect your Isa allowance, and what to do before the 5 April deadline.

How do Isa allowances work?

Unlike with normal savings accounts, which charge tax on interest garnered from having large sums of money in an account, an Isa is a tax-free savings account.

For the tax year 2017-18, the maximum amount you can pay into one – or a combination – of Isas held in your name, is £20,000.

Once the new tax year for 2018-19 begins on 6 April, your allowance resets – once again to £20,000. You cannot carry any unused Isa allowance over, so it’s best to use up as much as you can now.

Do different Isas have different allowances?

Yes. While your overall Isa allowance is £20,000, not all types of Isas will allow you to pay in the full amount.

There are five main types of Isas. The current annual limits are as follows:

Help to Buy Isa: Money can only be used to buy your first home, and savings receive a government bonus of 25%. You can save £1,200 in the first month, then £200 per month thereafter. Therefore, in the first year you will have a limit of £3,400. In the following years the limit will be £2,400.

Lifetime Isa: Expressly for first-time buyers or to be used in retirement once the account holder has reached the age of 60. There’s a 25% government bonus on savings up until the account holder is 50 years old. You can pay in up to £4,000 per year.

Cash Isa: A traditional savings account – money you pay in grows with the provider’s interest rate. You can pay in up to £20,000.

Stocks & shares Isa: Money you deposit is invested in stocks & shares by the provider. Returns can be higher, but so is the risk that you may end up with less money than you paid in. There will also usually be fees involved for managing your investments. You can pay in up to £20,000.

Innovative finance Isa: Money paid in is invested in Peer-to-Peer (P2P) lending platforms, and you receive the interest when this loan is repaid. There is also some risk involved. You can pay in up to £20,000.

Your overall Isa allowance of £20,000 can be used in its entirety in a cash, stocks & shares or innovative Isa, or can be split among all five types of Isas – up to a total of £20,000.

For instance, you could pay in £5,000 in a cash Isa, £5,000 in a stocks & shares Isa, £4,000 in a lifetime Isa, £2,000 in a Help to Buy Isa and £4,000 in an innovative finance Isa.

The split of your £20,000 Isa allowance would look like the graph below.

Your decision on how to split the money largely depends on what your savings goals are, your attitude to investment risk and which accounts you hold.

How to use the Help to Buy and lifetime Isa limits

Help to Buy and lifetime Isas are designed to help people buy their first home (or save for retirement, in the case of the lifetime Isa).

If you’re looking to buy a property, it may make sense to max out the allowances on a Help to Buy and lifetime Isa each year.

You can have both a Help to Buy and a lifetime Isa, but you can only use the bonuses from one of them to purchase your first property.

  • If you use the lifetime Isa bonus, you won’t be able to get the Help to Buy bonus but you can still use the money and any interest you’ve earned.
  • On the other hand, if you use the Help to Buy Isa bonus, you won’t be able to get your money out penalty-free until you’re 60. Take it out earlier, and you’ll lose the bonuses you’ve earned and pay an exit charge of 5%.

The maximum you can pay into these is £7,400 (£4,000 lifetime Isa limit + £3,400 Help to Buy limit) in the first year of a Help to Buy Isa, or £6,400 (£4,000 lifetime Isa + £2,400 Help to Buy) in the second year onwards of a Help to Buy Isa.

How does withdrawing money from Isas affect the Isa allowance?

You may want to spend money held in an Isa, but the effect this has on your Isa allowance depends on whether you have a flexible Isa.

Not all Isa providers offer flexible Isas, so you’ll need to check whether yours has this feature.

With a flexible Isa, you can withdraw money from a cash or stocks & shares Isa and put it back in the same tax year without it reducing your current year’s allowance.

For instance, if you have a flexible cash Isa and pay in £10,000, you’ll have a remaining £10,000 Isa allowance. If you then withdraw £3,000, your remaining Isa allowance will go up to £13,000 – freeing up more of your allowance.

If you don’t have a flexible Isa, this won’t happen. If you pay in £10,000 and then withdraw £3,000, your remaining Isa allowance will stick at £10,000 – essentially, once you’ve used the allowance, it remains ‘used’, regardless of whether you move the money or leave it where it is.

You cannot withdraw money from a Lifetime Isa unless it is to buy your first home, when you are over 60-years-old, or have been diagnosed with a terminal illness – doing so will mean having to pay a 25% penalty on your overall savings, which will mean paying out more than the government bonuses you have received.

Do Isa transfers affect the Isa allowance?

This depends whether you’re intending to transfer funds saved in a previous tax year, or the current tax year.

While there are no limits on the number of transfers you can make in a tax year, you can only make new contributions to one cash Isa and one stocks & shares Isa over this period.

If you want to transfer money already paid into an Isa in the current tax year, you must transfer all of it. Flexible accounts won’t count transfers towards your Isa allowance, but non-flexible accounts might.

You can move all or part of previous years’ Isa savings to any other Isas accepting transfers – this will not affect your Isa allowance for the current tax year.

Note that you can only transfer a lifetime Isa to another lifetime Isa, otherwise you’ll be charged the government withdrawal penalty of 25%.

What about junior Isas?

You can save up to £4,128 a year into a junior Isa. This does not count towards your Isa allowance because the money is being saved for the child – who won’t be able to access the money until they turn 18. This can be save either in a junior cash Isa, a junior stock & shares Isa, or a mix of the two.

The junior Isa limit will increase to £4,260 from 6 April 2018.

You can only hold a cash or stocks & shares junior Isa with one provider – if you spot a better deal elsewhere, you’ll need to transfer the account.

What if I exceed the annual Isa allowance?

If you have several Isa accounts, paying too much into them without realising is easy to do.

The banks won’t stop you paying in to your accounts (unless they’re capped, like the Help to Buy and lifetime Isas).

However, throughout the year Isa providers have to report how much each of their customers has invested to HMRC, so it will spot the mistake and will make contact with you.

The most recent contributions that took you over the limit will be identified and declared ‘invalid’, will be handed back to the investor, and tax will be charged on any returns made relating to this money (for example, if any interest was paid on it by the bank).

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