Deciding between a cash ISA and a stocks and shares ISA
In the 2016/17 tax year the annual allowance for an ISA is £15,240 and this can be split in any proportion between a cash ISA and a stocks and shares ISA. Generally speaking, stocks and shares ISAs have better growth potential than cash ISAs, but they can also fall in value and are more risky than cash ISA’s.
Once your money is in an ISA the tax man can’t get his hands on it and any interest, dividends or growth that it generates won’t be diminished by income tax or capital gains tax.
How can I buy an ISA?
Investing in an ISA is a two-part process. The first thing you have to do is choose your provider.
The second stage is picking the specific investments you want to put inside the ISA and you can do this on your own or get advice from a financial adviser. You can change the investments you hold within the ISA without affecting your annual ISA allowance. Be aware that in some circumstances, the ISA investments that can be applied to the ISA may be restricted by the ISA manager and by legislation.
A cash ISA works just like a savings account, except you won’t have to pay income tax on the interest you earn. Some cash ISAs will give you instant access to your savings, while others demand that you keep the money there for a fixed amount of time. You can also choose between a fixed interest rate or a variable interest rate for your savings.
Stocks and Shares ISAs
You can choose different investments for your stocks and shares ISA, and many companies offer fund solutions. These aim to make investing easy by offer a package of different investments held in one fund, designed to meet a risk appetite or a particular savings need.
Deciding between the two
There are three main factors to consider when deciding between a cash ISA and a stocks and shares ISA and these are: the length of time you’ll be saving/investing, your appetite to risk, and the impact of inflation.
If you’re saving/investing for the long term, typically a minimum of five years, then stocks and shares are likely to generate a higher rate of return. Indeed, if you hold your investment for a minimum period of 18 years, research shows stocks and shares will outperform cash 99% of the time.*
*Source: Barclays Equity Gilt Study March 2016, Figure 8 p61.
It’s true that stocks and shares are more volatile and that their value can rise and fall dramatically, but over time these peaks and troughs generally flatten out to create an upward trend.
The higher the risk profile of your investments the more likely they are to experience significant fluctuations in value and this is why it’s important to match the investment risks you take with your personal circumstances and the level of risk you’re comfortable with. If you’re not confident in choosing your own investments, a financial adviser can help identify your risk appetite and investments that are aligned to it.
In contrast, cash will rise in line with the interest rate payable on your cash ISA and, while the rate may be variable, it won’t change dramatically, delivering slow and steady growth.
But if inflation is higher than the rate of interest you’re earning on your cash ISA - and often it will be - the real value of your money will fall over time. Slowly the buying-power of your savings will be eroded and so keeping your money in cash isn’t a risk-free option as many savers believe.
This is particularly true in today’s low interest rate environment and between 2005 and 2015 cash offered an annual return of 1.4% while CPI inflation was running at 2.4%.**
As we're now at the start of the 2016/17 tax year, it’s important to think about how you'll use your full ISA allowance if you can afford to. And if you’re looking to maximise your returns in the long term then you should investigate how a stocks and shares ISA could help you do that.
**Source: Lipper for Investment Management. Cash returns are based on the ABI Money Market sector average.