Understanding the differences between investment ISAs and cash ISAs is crucial when deciding where to place your hard-earned money.
A cash ISA operates in a similar way to a regular savings account except that any interest you receive is tax-free. The only asset you can put into a cash ISA is cash.
In contrast, an investment ISA enables you to invest in a plethora of investment assets, including shares, bonds, funds and investment trusts. Your money can grow free from income tax and capital gains tax.
Deciding between the two ultimately comes down to how much risk you can take on, how long you’re putting your money aside for and your financial goals.
Cash ISAs tend to be more suited to people who are putting money aside for short periods of time – anything up to three years. This is because cash ISAs don’t expose you to stock market risk. The last thing you want is for your holdings to drop in value just before you need to access them.
The downside of cash ISAs is the interest rates are extremely low. The highest rates currently available are 2.3% for Shawbrook Bank’s five-year fixed ISA, and 1.82% for Charter Saving Bank’s two-year fixed ISA. With the current rate of inflation running at 1.9%, you’re unlikely to see any real growth with a cash ISA.
If you want the opportunity to grow your money, an investment ISA is the better option. The Barclays Equity Gilt Study shows that if you hold your investments for at least 18 years, stocks will outperform cash 99% of the time.
It’s important to remember that investing carries risk. This makes investment ISAs more suitable for people who are setting aside money for the long term – at least five, or even 10, years. You should also have easily-accessible cash set aside in case of emergencies, such as a period of unemployment or your boiler breaking down.
“Harnessing the power of investing and compound growth is particularly important over longer periods of time as inflation can eat away at the value of your cash savings,” says AJ Bell’s senior analyst Tom Selby. “A long time horizon of five or 10 years plus gives enough time to ride out any periods of short-term volatility that might be experienced when investing in the stock market.”
It’s a good idea to have a solid understanding of investment principles before opening an investment ISA, especially if you want to pick investments yourself. Some ISA providers offer ready-made portfolios if you’re unsure which underlying investments to choose.
There are some ISAs which operate in between investment and cash ISAs. Wise Alpha’s Innovative Finance ISA, for example, offers more potential for growth than a cash ISA with fixed returns of up to 8%. The product invests in corporate bonds and is therefore billed as being more stable than a traditional investment ISA. A major downside of innovative finance ISAs is they aren’t covered by the Financial Services Compensation Scheme.
Choosing between investment and cash ISAs doesn’t have to be an either-or decision. You can spread your £20,000 annual allowance across both ISAs, enabling you to have different “pots” for short- and long-term goals.
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Emily Perryman is a freelance financial journalist with over a decade of experience writing for national, consumer and trade publications. She specialises in investments, pensions, property, fintech and tax. Emily was previously the personal finance editor at Shares magazine.