Are you using your Isa to its full potential?

Kat Cereda: More than 20 million of us have an ISA in the UK. But are you missing out on some of the perks the tax-free savings product offers?

Hi, it’s Kat joining you from the Which? studio, filling in for James on this week's Money Pod. Today we're talking about ISAs. Now, I must confess, I only recently entered the world of cash ISAs, which I know, I work at Which?, not a great look. But the good news is, I'm with two wonderful experts today who are going to teach me and you all about them and their hidden perks.

So to help me today, I'm joined by Sarah Coles from AJ Bell. Thank you for joining us, Sarah.

Sarah Coles: It's very nice to be here.

Kat Cereda: And I'm also joined by Which? money expert Matthew Jenkin, who by complete coincidence has recently done a very successful article on the hidden perks of ISAs. So we're going to dive into that today. Thank you for joining.

Matthew Jenkin: Good to be here too.

Kat Cereda: Right, Matthew, I'm going to come to you first. I want us to touch on the basics – just for two minutes or so and then we'll get into the good stuff. What is an ISA in simplest terms?

Matthew Jenkin: ISA stands for Individual Savings Account. There's lots of different kinds. The most popular are cash ISAs and stocks-and-shares ISAs. A cash ISA works in a very similar way to a savings account and you've got lots of different kinds – so you've got an instant access and you've got fixed-rate accounts. But what they all share in common is that you can save up to £20,000 tax-free per financial year.

Kat Cereda: But the interest won't be that much, right? So why is it so important that it's tax-free? What's the real benefit?

Matthew Jenkin: Well, the interest could be a lot. For example, the top instant access at the moment is up to 5%. That's on a normal savings account. And if you have quite a large sum of money, you could easily go over your personal savings allowance – which is £1,000 for a basic-rate taxpayer, but that drops to £500 if you're a higher-rate taxpayer. So you could quite easily go over that limit and end up with a tax bill. So a cash ISA is a really great option if you are going to be in that position.

Kat Cereda: But there's some changes coming up soon, Sarah. Can you tell me about them?

Sarah Coles: So it's – the announcement's been that from next April, the allowance on the cash ISA for anyone under the age of 65 is going to drop to £12,000. So those people who are over the age of 65, they can still put £20,000 a year in, but if you're younger then unfortunately your limited to £12,000. There's also, as a result of that, a whole heap of complications have come in. Because at the moment, it's really easy to switch. You can go from a stocks-and-shares ISA to a cash ISA and vice versa and you can do it as many times as you like in any time of the year that you fancy. Under the new rules, you won't be able to do that switch because you've got different allowances. It will be very difficult for you to switch from one to the other until obviously you're 65 and then those rules change.

Kat Cereda: Then happy days. But I've read some of your research you've done recently, and you've said that 49% of people say that these changes won't impact what they do with their money. They're going to keep saving; they might just move it to a non-ISA account. Tell me your thoughts on that.

Sarah Coles: I think for a lot of people, the cash ISA allowance – in a random year out of nowhere – of £12,000 is enough. So there are lots of years in which you're not going to be saving more than that. It's just that there are also lots of years in which you'll need that amount of money. So you might, for example, let's say you're saving really strongly towards something like university fees. You might want to be putting a lot of money aside for that. And obviously, once you've got into the realms of university, which is currently where I am at the moment, you realise just how expensive that is and just how much you need to save.

So there will be years where people will want to save more. But what we've found is about half of people are comfortable that they can still save what they need to within that allowance. It's just then a question of what the people who don't have enough – they've got this £20,000, they want to do something with it – what do they then do with the bits that they can't put into a cash ISA? So under the rules, you could put the rest into a stocks-and-shares ISA. It's just that a lot of people won't. So there's a big chunk of people who just will put the money into savings elsewhere, which means that they could run into this whole having to pay tax on the interest on their savings.

Then there are some people who'd invest – so 13% of people said that they would invest in UK stocks-and-shares, which is what the government would like them to do. But that's still a fairly big chunk of people who aren't going to do what the government wants them to do. And then when you look at all the other weird and wonderful things people plan to do with the money, there's a whole heap of things that you wouldn't necessarily want people to switch – so for example, you've got 5% of people say that they would put their money in cryptocurrency.

Kat Cereda: I wanted to bring that up with you because that's such a non-conventional investment method, right? I've associated that with people who are off the system kind of vibe. But the idea that people are considering that because of ISA changes – I was quite surprised by that. I mean, what do you guys think?

Sarah Coles: Absolutely. And they couldn't be further on opposite ends of the risk spectrum than cash and crypto. So obviously cash – your money is protected, there is the whole risk-reward thing with cash is that you don't get vast amounts of interest, but in return you're not taking a big risk. Whereas with crypto, you could lose everything overnight. So it couldn't be more different. So the idea that you're propelling people into making possibly not the best decisions as well is perhaps a really tricky element of this change to the cash ISA limit.

Kat Cereda: And Sarah, there are people you say who plan just to spend it.

Sarah Coles: Interestingly, the figures also showed that about 8% of people said that if they can't put the money into a cash ISA, they're just going to spend it. So from a government perspective, that's not a terrible thing because obviously you're putting the money back into the economy and lots of growth and all that sort of thing. But if you do need to save that money, then that's not going to be the right option for you. So the really important thing to do is take a step back. If you've got this £20,000, if you wanted to save it all, what works for you? What else do you have in terms of savings, in terms of maybe things that you've got tied up for a bit longer, maybe investments? And then you make that decision based on what's right for you rather than what maybe seems sensible in the moment – and if that's crypto, then that would be a bold choice.

Kat Cereda: Some people might think that when they put money into an ISA, it's locked away and they can't touch it. And I think, Matthew, you spoke earlier about how there are different types of ISAs. Some of them the money is locked away for a period of time; sometimes you do have instant access. Do you notice a pattern in how people are using ISAs?

Matthew Jenkin: I wouldn't be able to comment on a pattern on how people are using ISAs, but definitely you can open an instant access ISA and still have access to your money – as the name suggests, the clue's in the name there. So as I said, they work pretty similar to a savings account. But one thing I think you probably should watch out for if you are using your cash ISA for an as an emergency fund or you want to have quick access to that money is that some of the higher rates may come with catches – for example, limited access. You may only be able to take so many withdrawals a year and often they're the ones with the highest rates. So just be careful when you are opening an instant access to make sure that if you're using it as an emergency fund, that you are going to be able to get that money without taking a hit in interest.

Kat Cereda: Sarah, what's your thoughts on that? Do you find that people do tend to treat the money they put in ISAs as untouchable and as emergency funds?

Sarah Coles: The money in ISAs actually tends to be pretty sticky. So once people have put money into ISAs, they just tend to hang on to it for longer than they might in an everyday savings account. But still, what you find in any savings market is the really most popular by a long chalk is easy access. So you do end up in a weird position where a lot of people end up putting money into an easy access cash ISA and then leaving it there. And I hate to bang on about the importance of looking at the holistic picture, but actually do think – can I tie this up? Particularly at the moment when you've got some quite strong rates available on longer term. You think, well, if I don't need this money for a year, two years, five years, whatever it is, maybe I ought to be getting a fixed-rate account so I can guarantee what my rate's going to be. And if I don't need it for more than five years, maybe I ought to be investing. So there's always that comfort blanket of, oh, I'd quite like it to be an easy access just in case something happens, but there can be some really huge chunks of cash sitting here that might be able to be working a bit harder for you.

Matthew Jenkin: I was going to add as well that some people might be put off by the difference in rates as well and they may think, well, you can get a better rate with a fixed-term savings account as opposed to a cash ISA. But if you are at risk of tax – and the difference is actually quite small between the top fixed-rate cash ISA and a top fixed-rate savings account – and you might opt for the higher rate, which would be with a fixed-term savings account, but if you are at risk of paying tax, then that difference is immaterial. So you would be better off putting it into a cash ISA. So don't be put off by slightly lower rates.

Sarah Coles: Historically, that gap between what you can get in an ISA and what you can get in a fixed-rate savings account has been a lot bigger. It's actually a really small gap at the moment. And in the easy access market, actually cash ISAs are ahead of the normal savings account. And that's because there's a huge amount of competition. There's a lot of challenger banks really keen to get into this market and so they're really competing hard against each other, which is why you've got some really great rates. In the fixed-rate account, you do have the traditional setup where you get slightly less in a cash ISA. And that's purely because it's actually more expensive to run a cash ISA. There's a lot more legislation that companies have to go through, make sure that they hit various reporting things and it's lots of exciting, expensive admin for them to do, which is why they tend to offer slightly less.

But it is very slightly less. And if you think about – if you're a basic-rate taxpayer, then you've obviously got quite a big personal savings allowance, which is the amount of interest you can make before you have to pay tax. But when you cross over into being a higher-rate taxpayer, then that will halve. And then when you cross over into being an additional-rate taxpayer, that allowance disappears altogether. And also, we do know from recent things that have changed maybe that those tax rules are just never written in stone. So you can't always guarantee that those allowances will exist. So it is worth thinking not necessarily – oh, I'm maybe a basic-rate taxpayer with a small amount of savings, do I need to bother? But actually – well, will I be a higher-rate taxpayer in future? Am I expecting to build my savings? Am I worried about the tax rules changing? And in those circumstances, you might think it's worth actually having that security of knowing that it's in an ISA and therefore protected from tax regardless of everything else that might change.

Matthew Jenkin: And next year as well – I'm not sure if we mentioned – the income tax on savings interest is actually going up by two percentage points. So your bill's going to be even higher from next April.

Kat Cereda: So we've talked a bit about emergency funds and whether people treat them as untouchable. But what happens if you are to withdraw some money from your emergency fund? Are you able to put that back in or is that not really an option?

Sarah Coles: There are two types of cash ISAs. You've got your flexible cash ISA and that – what that lets you do is if you take money out during that tax year, you can then top it back up without it counting as extra allowance being used. Non-flexible cash ISAs, if you were to do that, then the money that you put back in would count as using up more of your allowance. So if, say for example, you put in £10,000, you spend £9,000, and then you top it back up with £9,000 again, that total of £19,000 would count as the amount that you've used. Whereas if you have a flexible cash ISA, then it doesn't count as extra allowance being used. Now, if you're not going to be taking out £10,000 and adding £10,000, you might not be terribly worried about it. But it does give you that extra flexibility.

And obviously with that lower allowance coming in, it does mean that you're not constrained by the £12,000. What I would say is that typically, because there are fewer companies providing flexible cash ISAs, that you might have had to make a bit of a compromise in terms of the amount of interest that you were going to earn. But actually a lot of those new competitor banks that are really fighting for your money, a lot of them are actually offering flexible cash ISAs. So it is worth having a look around for what is the most competitive flexible cash ISA and see how much of a compromise, or if you need to make a compromise at all, on that income.

Kat Cereda: And the upcoming changes, that doesn't impact anything of what you've just spoken about?

Sarah Coles: Just purely that if you're topping it up – let's say, in the same example, that you put in £10,000 and took out £9,000 in a non-flexible ISA – then you wouldn't be able to put £9,000 back in. If you were limited to £12,000 altogether, you put in £10,000, you take out £9,000, you could only put £2,000 back in. So it constrains you a little bit more in terms of how much topping up you can do if it's not flexible. Flexible cash ISAs, you're laughing because you can top it right back up again.

Kat Cereda: It's not just income tax that an ISA can shield you from, is it? There's a capital gains angle too. Can we talk about that?

Sarah Coles: So that's really when you're looking at a stocks-and-shares ISA. So when you're investing, there are two types of tax that you can get exposed to. So if you're outside an ISA, then you can pay tax on your dividends, which is the income that you get from shares and from funds, and you can pay tax on the capital gain. So that's the amount of profit that you make on the investments. Now, two things have changed with both of those. So actually in recent years, the allowance on both has come down – so you can make less before you start paying tax. What happened in April is the rate on dividends went up as well. So you've got this tax squeeze where the allowances on both have gone down and the rate on both has gone up. So you're getting squeezed much harder.

If you put that investment into an ISA – so a stocks-and-shares ISA – then there is no tax to pay. So it's completely free of dividend tax and capital gains tax. And what's really useful with that is if you actually invest on a platform, it means you can buy and sell different investments without worrying about tax. So if you were to do that outside an ISA, every time you buy and sell you've got to think – how much of a gain have I made? How much of my annual allowance have I used? How much have I got left? Whereas if you're inside an ISA, you don't have to worry about it, so it gives you a lot more flexibility and freedom.

Kat Cereda: That sounds like quite a loophole there. Sounds like quite a good thing to get into. Matthew, in your article you talked about something called fiscal drag. Can you explain this to me in as simple as you can and why it's something that ISA holders should care about?

Matthew Jenkin: Fiscal drag, yeah. So – begrudgingly – fiscal drag is basically where – well, let's roll back a bit. So income tax thresholds have been frozen since 2021 and as wages have risen, there's more people being pushed into a higher tax band as a result. And that is in a nutshell what fiscal drag is. And income tax thresholds are still frozen. The more you earn, the more likely you are to get pushed into one of these higher tax bands and have a bigger bill. But because you can stash up to £20,000 a year without interest counting towards that taxable income, an ISA can actually help lessen your risk of breaching any of these thresholds.

Sarah Coles: One thing I would say is that fiscal drag affects you in your savings and your investments. So if you move into that higher rate of tax – let's say you move from basic rate to higher rate – then you've got this change in your personal savings allowance and you've got a higher rate of tax on the savings and on dividends and on capital gains. So you're hit in all these different areas just by crossing a tax band. It is worth saying that there are also things you can do to stop yourself crossing a tax band. So I'm not saying – please don't give me a pay rise, whatever you do. But one of the things that when they're calculating whether you've crossed that band, your pension contributions will be taken off. So actually by paying into a pension, you can bring down the amount of your money that counts towards whether or not you've crossed the threshold and you could bring yourself down below the threshold and save yourself a load of tax all these different areas as well. So if you're actually on the cusp of that, it is really worth looking at whether or not you can increase your contributions and save yourself quite a lot of tax headache.

Kat Cereda: When I was reading through your article, Matthew, my ears really pricked up at the mention of a student loans benefit. As someone who is paying off their student loan every month – it just feels like another tax to me on my payslip – can you talk us through what that is and should all working students be excited by what this is or does it not apply to all students?

Matthew Jenkin: So to explain how student loans works – so repayments are usually they're based on your salary. So deductions are then automatically taken through your payslip once you earn above the threshold. However, if you complete a self-assessment tax return, some types of unearned income, including taxable savings interest, they might need to be declared and taken into account when calculating repayments. Now where ISAs come in is interest earned inside an ISA is tax-free as we've discussed, so it doesn't count towards your taxable savings income. That means you can use an ISA to help you avoid increasing the income figure using those calculations. So it's a great way to make money on your savings without increasing your student loan repayment.

Kat Cereda: So I want to finish on what I think is the most surprising part of your article. And it's something that impacts people at a really difficult and emotional time – and that's what happens to an ISA when somebody dies and what are their partner's rights?

Matthew Jenkin: So ISAs – money in an ISA, just like any other savings, they form part of your estate when you die. So your surviving spouse or civil partner can usually inherit these funds without paying inheritance tax. But what makes an ISA different is that your partner can also keep the tax-free benefits. So since 2014, bereaved spouses and civil partners have been allowed to reinvest cash and investments held in their partner's ISA and that's because of an allowance called the Additional Permitted Subscription – APS. Let's call it APS. Really catchy, that, isn't it? Could have thought of a better name. ISA works, but that one doesn't. But just as a warning, not all ISA providers actually allow people to do this. So you'll need to check with your provider to make sure that they do accept these extra deposits before transferring anything. But if they don't, all is not lost because you're always free to open another one that does. So even if you've used part of your ISA subscription for the current tax year, you can still do it.

Sarah Coles: That additional permitted subscription's on top of your current tax year's ISA. And one of the other things I find very interesting about this rather dull APS is that you don't have to leave the ISA to your spouse in order to leave them your ISA allowance. So they automatically inherit the allowance even if you were to leave your ISA to your kids. The spouse would get that allowance anyway, so they could wrap up different investments and savings in an ISA allowance. So it's a weird extra bonus that they get even if you don't leave them your ISA.

Kat Cereda: And is this something that you find in your experience that many people are aware of or is this something that kind of gets overlooked and people don't realise that they're able to inherit it like this?

Sarah Coles: So we did a piece of research actually looking at the questions people are likely to ask about ISAs. And one of the big questions was around whether or not you can inherit it. The most common question that anyone asks about ISAs is what does an ISA stand for? And it's not helpful that it stands for something completely meaningless. So it's Individual Savings Account and in some instances, it's for investment – so that doesn't make any sense. But yeah, one of the most common questions is around this inheritance thing, so it is worth getting to grips with.

There's lots of other bits and bobs around ISAs that people, for example, are worried about whether or not they can have a joint ISA with another person. So if they're saving with their partner, they're concerned about whether or not they can get a joint one. You can't actually get a joint cash ISA. But there is nothing stopping you saying – well, we're saving towards this joint endeavour, but I'll put money into my cash ISA and you put money into yours and we'll just do it that way. So you can bring them together later. So as long as you've got a joint agreement between you, you don't necessarily need a specific joint product to make it work.

Matthew Jenkin: You can also max out other ISA allowances – for example, if you've got kids, you've got £9,000 per child for a junior ISA. So if you're a family, you could pool those resources.

Kat Cereda: My last question for both of you is – if someone's listening to this and thinking, right, learned a lot about ISAs today, better get it all sorted – what's the one thing that you'd want them to take away from our conversation today?

Matthew Jenkin: Not enough people are maybe using their allowances – they're not maxing out if you've got the money to do so. You've got £20,000 this year, but obviously with changes coming in next year, it's really important if cash is really important to you to take advantage of this year before that allowance is cut for those under 65. But also, it is worth considering a stocks-and-shares ISA as well. There's lots and lots of benefits, especially if you do have a large pot of money and you're thinking about long-term returns. So I think it is an opportunity to also consider that as an option if you are somebody who does have a large pot of money and can max out that £20,000 allowance. I think investing could be a very lucrative – a good option for you.

Sarah Coles: And I would also say that as someone who hates admin, when you're thinking – oh, I've got to think about where I'm going to save, where I'm going to invest and go through the process of applying and all the rest of it – focus on the admin that you're saving by getting a cash ISA or by getting a stocks-and-shares ISA. Because in both cases, you don't have to put them on your tax return. So it doesn't matter how much money you're making on them, you never have to do the boring admin of putting it on a tax return. Whereas if you invest outside a stocks-and-shares ISA, that goes on your tax return. If you have savings, that has to go on the tax return. So there's a bunch of admin you have to do if you don't use your ISA allowance. So consider it how amazing is it going to be – you're going to save yourself time every year by doing it.

Kat Cereda: All right, well, thank you so much for coming on the podcast today. I've certainly feel like I've become a connoisseur in ISAs now, having just opened one. But thank you very much for coming on the show today. I'm sure there's a link that we can pop in the show notes to take us to your wonderful and very informative article and to your recent stats as well and your recent research as well. We'll make sure to pop that in, so make sure to check that out. Thanks for joining us.

Matthew Jenkin: Thanks for having me.

Sarah Coles: It's been an absolute pleasure.