Smart Money Moves: How to Leverage Tax-Free Accounts for Financial Success in the UK
by elmads
Introduction
If you work and live in the UK and are thinking of saving money, then looking into the UK’s tax-exempt Individual Savings Account will be the right path for you.
Spending your money now is your ability to enjoy the present, while spending your money for tomorrow is being mindful of your future happiness and contentment.
It’s striking the balance in your life’s fulfilment and happiness between multiple timeframes.
First and foremost, before you’re able to save money, you will need to earn money. You can’t save a dime if you don’t earn anything, and certainly, you can’t save money when your earnings can’t even support your essential life expenses.
Therefore, focus first on earning money, and the common path is to have a job. Strive to earn money well to cover your essential needs; if this is not the case, then continue to earn more by aiming for a job promotion or learning how to buy and sell goods and/or services. Expand your knowledge and skills and follow your inclinations; eventually, money will follow.
Always make an effort to increase your income in order to cover your MOST ESSENTIAL NEEDS, not to earn more in order to keep up with the Joneses, commonly known today as keeping up with the Kardashians.
Putting that aside, once you have a good income flow that can cover your basic needs in life, you can now focus on saving money for different purposes, such as an emergency fund, a rainy day fund, getting life insurance, and your other aims in life (purchasing your first home, travel purposes, a car, citizenship, higher education, retirement, and starting your own business, to name a few).
But how exactly, Evan? There are a lot of banks and financial institutions that offer different financial products. Even looking for a single savings account is overwhelming.
This is the reason I made this blog. I want to write about one of the very important things that I think everyone in the UK who wants to save money needs to know, which is the UK’s tax-exempt Individual Savings Account.
Individual Savings Accounts (ISA)
I’ve already written about individual savings accounts (ISAs) and their different types in detail in my blog titled UK’s Tax-Exempt Individual Savings Account (ISA).
📣 https://elmads.com/?p=1738 — UK’s Tax Exempted Individual Savings Account
Thus, I won’t be discussing each account in detail. To explain what an ISA is, I’ll use the definition given by the UK government on their website.
“Individual savings accounts (ISAs) were introduced on April 6, 1999, replacing the earlier Personal Equity Plans (PEPs) and Tax-Exempt Special Savings Accounts (TESSAs). ISAs are tax-exempt cash, stocks, and shares and/or innovative finance accounts under which any income received in the form of interest and dividends is free of tax and on which there is exemption from capital gains tax on any capital growth.” —https://assets.publishing.service.gov.uk/media/621fa223d3bf7f4f04b2b6ac/ISA_Statistics_Release_June_2020.pdf
To illustrate, I’ll show you two different savings accounts from Barclays Bank. See the image below.
The top portion of the image is a 1-year flexible cash individual savings account, while the other is a 1-year fixed rate savings account. Direct your attention to the yellow arrow on the image for each savings account.
As indicated in the Cash ISA, the interest income that you’ll be receiving if you subscribe to this savings account will be tax-free. Meaning that the 4.75% interest rate is the actual rate you’ll be receiving. Whereas the 4.85% interest rate in the 1-year fixed-rate savings account is only at a gross rate. The interest income you’ll be receiving in this account will not be exactly 4.85% because taxes will be considered.
NOTE: In the UK, most people can earn some interest from their savings without paying tax. Your allowances for earning interest before you have to pay tax on it include:
your personal allowance, starting rate for savings, and personal savings allowance
You get these allowances each tax year. How much you get depends on your other income. The tax year runs from April 6 to April 5 of the following year. For further information, see the link provided below, taken from the UK government website.
Tax on savings interest: How much tax you pay – GOV.UK (www.gov.uk)
Utilize each account based on your personal financial goals
Each individual savings account has its own pros and cons, and by understanding them, we can optimise each strength to achieve our own personal financial goals.
When you plan for your finances, where do you usually base it? Obviously, we have our own wants and needs. Then what’s next? We plan on how we achieve this goal, and usually this is done through timeframes. What do I mean by this?
It categorises our financial goals based on time. Short-term, medium-term, and long-term.
- Short-term (today to 3 years).
- Medium-term (3 years to 10 years)
- Long-term (10 years and more)
The number of years is arbitrary, which I’ve personally chosen and practiced because there is no clear-cut definition for its exact time frames, and mostly this is based on an individual’s preference.
This is paramount in any financial planning because this is one of the core bases on which you’ll be allocating your finances, and it will also help you decide what type of account will be suitable for each penny you have in your name.
Now let’s use this concept with individual savings accounts, starting with a cash ISA.
Cash ISA
This is a straightforward account because it is the same as any other savings account, where you receive interest either every month or yearly, depending on your preference. The only difference is that your interest income is tax-free.
There are different types of cash ISAs offered by different banks in the UK, such as flexible and fixed-term.
Flexible ISA accounts are easy to access because you can withdraw money any time or a specified number of times only within a year, and you’ll still receive an interest income.
Conversely, fixed-term ISA accounts have locked-in periods of 1 to 5 years or more. You won’t be able to withdraw your money for a certain number of years. Your interest income received in such an account is also tax-free.
Why open a cash ISA? It can be used for your financial protection, such as your emergency fund or rainy-day fund. Additionally, for your short-term goals, you expect to spend your money within 3 years. This can be a planned trip, clothes or shoes you plan to purchase, or any expenses you just want to be ready for. It’s always nice to get away from the taxman and be ready for any unexpected or expected short-term financial expenses.
The downside is that most interest rates in savings accounts are low and are always less than the annual inflation rate.
Below are images of cash ISAs offered by Barcalys Bank, Paragon Bank, and Moneybox. There are a lot more banks, building societies, and other savings and investment businesses that offer cash ISAs. Each type of cash ISA offered is different, so always read the terms and conditions to help you make an informed financial decision.
Lifetime ISA
You can use a lifetime ISA to purchase your first home or save or invest money for your later years (aged 60 years or older). This is the only reason why you should be using a lifetime ISA.
In the 2023–2024 tax year, you can contribute a maximum of £4,000 to this account. The government will add a 25% bonus to your savings for every amount you contribute.
So, if our maximum allowed individual contribution is £4,000 in a lifetime ISA, then the maximum bonus that the government will add is £1,000 (25% of £4,000 is $1,000).
You must be at least 18 years old but under 40 years old to open a lifetime ISA.
Additionally, when you reach age 50, you will not be able to contribute to your lifetime ISA or earn the 25% bonus anymore. Your account will stay open, and your savings will still earn interest or investment returns.
Lifetime ISAs are offered by UK financial institutions in both stocks and shares, and savings accounts.
Using the timeframe concept, this account will be applicable for our long-term financial plans. If we’re only allowed to open a lifetime ISA at the latest age of 40, then we’re only allowed to withdraw money at the least age of 60, so we have a 20-year gap between the two.
This coincides with the long-term financial plan timeframe for saving and investing our hard-earned money that we would not need for more than 10 years.
The lifetime ISA also makes it easier for you to decide if this is applicable to you or not. Are you planning to buy your first home in the UK? Or are you looking into saving specifically because you’ll only need it once you’re 60 years of age and older?
If yes, then a lifetime ISA could be suitable for your long-term financial goals.
📝NOTE: If you already own a home, written under your name by law, in a different country, then you won’t be able to use the funds you’ve saved in a lifetime ISA.
You must be a first-time buyer to put the lifetime ISA towards your first home. A first-time buyer is someone who does not own, and has never owned, a home anywhere in the UK or the rest of the world.
Which type of LISA should I choose? A savings account or stocks and shares? This depends on your risk appetite, your willingness to learn about the basics of investing, and your timeframe (we already know the answer for the timeframe, which is for long-term financial aims—more than 10 years).
To learn more about the basics of investing, see my blog titled.
On the one hand, if you’re risk-averse, don’t like to see the short-term volatility in the price of your invested capital, don’t want to learn the basics of investments, and might get anxious about market dynamics, then opt for a savings account type of LISA. low-risk, stable cash flow but with fewer returns compared to stock and share accounts.
On the other hand, if you can handle and manage risk in market prices, price volatility is not a substantial issue with you, and you are open to learning about the basics of investing, then you can try to open a stocks and shares LISA. For high-risk, erratic market prices but with higher returns compared to savings accounts.
You just have to choose which one you’ll be comfortable with. Though you can have both, you can only contribute to one account within a tax year.
For example:
- Year 2023, stocks, and shares; lifetime ISA – £4,000 contribution
- Year 2024, Cash Lifetime ISA – £4,000 contribution
- In 2025, you chose again to contribute to your stocks and shares LISA account, which you opened in 2023.
You can only contribute to one specific LISA in a tax year. So, choose with prudence.
I’ve made a LISA calculator spreadsheet, which you can download for free below.
Below are images of my Lifetime ISA Spreadsheet.
My reason for sharing this with you is to give you an overview of the possible amounts you can save depending on whether you take the lifetime stocks and shares ISA or its savings account type.
I hope this helps you with your financial decision about whether a LISA will benefit your financial plans.
The below image shows two of the many providers of LISA accounts in the UK.
Stocks and Shares ISA
As the name implies, it is an ISA for investments in stocks and shares. You’ll be investing your hard-earned money in a piece of business for capital appreciation and dividend payments. The income you’ll receive is tax-free.
I’ve written many blogs regarding the basics of investing in the equity asset class (stocks and shares); see blog links below.
- 📣 https://elmads.com/?p=10619 — Investing 101: Everything You Need to Know About Why, How, When & Where
- 📣 https://elmads.com/?p=1548 — How Shares are made and how the Stock Market works
- 📣https://elmads.com/?p=1669 — Stocks and Shares
You can open a stocks and shares ISA as early as 18 years old. You can invest in shares of companies, investment funds, corporate bonds, and government bonds.
Stocks and shares ISAs are usually provided by investment broker institutions and large banks in the UK.
When investing in a stocks and shares ISA, you must primarily consider that this is a high-risk investment option where your initial investment can go up and down in a short period of time. Thus, you must, as much as possible, only invest money that you won’t need for at least 10 years.
This means that your emergency fund, rainy day fund, and short- to medium-term expected expenses shouldn’t be placed in a stocks and shares ISA unless you’re willing to take very high-risk investments.
At the end of the day, what you do with it is your own decision; you just have to take accountability for its outcome, whether good or bad; it’s all on you.
📝 NOTE: You can take your money out of an ISA account anytime without losing the tax benefits. You must be aware of the withdrawal rules of your chosen stock and share ISA provider.
There are two withdrawal rules: flexible or not flexible. If your ISA is ‘flexible’, you can take out cash and put it back in during the same tax year without reducing your current year’s allowance. Your provider can tell you if your ISA is flexible.
Let’s say, for example, that your allowance is £20,000 and you put £15,000 into an ISA during the 2023–2024 tax year.
- You then take out £5,000. The amount you can now put in during the same tax year is £15,000 if your ISA is flexible (the remaining allowance of £10,000 plus the £5,000 you took out).
- If your account is not flexible, then the remaining allowance in our example scenario will still be £5,000 (the personal allowance of £20,000 minus the total invested amount of £15,000), despite withdrawing £5,000.
If you plan to purchase your own home, a car, or other things after a decade, then it’s worth considering a stocks and shares ISA. If you’re not willing to learn about the complexities of investing in businesses, it would be beneficial for you to just choose index mutual funds, or ETFs, as an option.
To learn more about the basics of this, please see the blog links provided below.
- 📣https://elmads.com/?p=1952 — Mutual Funds
- 📣 https://elmads.com/?p=1982 — Passive and Active Funds
- 📣 https://elmads.com/?p=2335 — Popular Investing Strategies
- 📣https://elmads.com/?p=4958 — The Power of Cost Averaging Investment Strategy
Using the Three ISAs Together
In a given tax year, let’s use 2023–2024, the ISA allowance is £20,000. This is the maximum amount you can contribute to your ISA.
The good part here is that you can contribute to your cash, lifetime, stocks, and share ISAs, provided that you don’t exceed the yearly personal allowance of £20,000.
For instance,
- Cash ISA: £6,000
- Lifetime ISA: £4,000 (this is the maximum contribution allowed for this type of ISA in tax year 23/24)
- Stocks and Shares ISA: £10,000
Adding the three ISA accounts gives us a total of £20,000.
By Timeframe
This is only a fictional money allocation that I thought of.
1️⃣ Cash ISA: £6,000
Breakdown:
- Easy Access Cash ISA: £4,000.
Purpose: for emergencies, rainy-day expenses, and/or within-the-year planned expenses such as travelling and purchasing items. - (1, 2, or 3 years) Fixed-term cash ISA: £2,000.
Purpose: for your planned expenses—usually for discretionary expenses or your wants. Once the term matures, you can move this money into an easy-access cash ISA. Why? Well, because you will need the money soon, and at least your money will still generate interest income even in a short period of time.
2️⃣ Lifetime ISA: £4,000 (either stocks and shares or savings account type)
If you have more than 10 years of investment time horizon, then you can take advantage of the stocks and shares type of LISA; if not, then opt for the savings account type. This is a way of managing stock and share market price fluctuations.
Either you use this to purchase a home or for your later years of spending (60 years old and older), this would prove beneficial for you in the long run if used in relation to your long-term personal financial goals.
3️⃣ Stocks and shares ISA: £15,000
For long-term financial goals, especially if you’re invested in shares of a company.
If you are looking to make your money work for you for your medium-term financial goals, then you could use a fixed-term, 3–9-year type of cash ISA.
If you’re not looking to purchase a home and want to specifically invest for your retirement, don’t opt for a lifetime ISA; instead, use a self-invested personal pension (SIPP).
Unlike lifetime ISAs, where the maximum yearly contribution is £4,000, SIPP allows a maximum yearly contribution of £60,000. The government also adds 25% on top of your contribution, and your employer—if they agree—can also contribute money to your SIPP.
Additionally, if you want to save money for your children’s future, like their education, There is a Junior ISA, where the amount of money you contribute to the account can only be accessed by the child when they’re 16, but they cannot withdraw the money until they turn 18.
The chart above was taken from Gov.uk Commentary for Annual savings statistics: June 2021. This is the most recent data regarding ISAs.
To Sum It Up
Leveraging the UK’s tax-exempted Individual Savings Accounts (ISAs) is a strategic approach to saving money.
Prioritize earning before saving, focusing on essential needs, and gradually increasing income.
Understand the different ISAs, including Cash ISA, Lifetime ISA, and Stocks and Shares ISA.
Tailor your savings strategy based on short-term, medium-term, and long-term financial goals.
Consider a thoughtful combination of ISAs, staying within the annual allowance of £20,000, to optimize savings for various purposes.
If you’re wondering what ISA accounts I have,
I have a Paragon Bank Cash ISA for my short-term goals.
Emergency and rainy-day funds are in an easy-to-access account.
For the money for my medium-term goals, it is placed on a fixed-term cash ISA.
I have a self-invested personal pension and a stocks and shares ISA, both of which are under Vanguard Investment Broker. I don’t have a lifetime ISA.
The rest of my money for my long-term goals is in general investment accounts.
There is no such this as a perfect way to manage your money, but there is a right way specifically for you, which again is based on your own priorities in life.
You have to do you and learn how to strike a balance between your today and the future you.
“The key takeaway, I now realize, is to strike the right balance between spending on the present (and only on what you value) and saving smartly for the future.”
—Bill Perkins
Knowledge is my Sword and Patience is my Shield,
elmads
This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.
0 Comments