ISA vs savings account: the differences explained

What is an ISA?

An ISA – or Individual Savings Account – is a popular saving or investing vehicle that offers advantageous tax benefits.* You can save a total of up to £20,000 per tax year from your net income across multiple ISAs, and returns are free of income tax, capital gains tax or dividend tax.¹

There are four key types of ISAs, each with its own set of advantages and drawbacks.

Cash ISA

These include instant access, regular savings and fixed rates. They are usually touted as 'low-risk' because the savings interest is tax-free and the initial capital protected. However, if the interest rate is lower than inflation, the value of your cash will fall in real terms over time.

Stocks and Shares ISA

This ISA type allows you to invest in shares, bonds and investment funds completely free of capital gains or dividend tax. As with all investing, returns aren't guaranteed, and you may get back less than what you put in. However, equities have historically outperformed cash over the longer term.

Lifetime ISA (LISA)

You can save up to £4,000 per year in a LISA, which is then topped up by 25% by the government, up to £1,000 per year until you turn 50. If you invest the full £4,000 allowance, this leaves you with £16,000 to invest in other ISA accounts. The money must be used to buy your first home, or it can be withdrawn at the age of 60. You must be over 18 and under 40 to open a LISA. You can invest in cash or shares as usual. Early withdrawals come with a penalty charge.

Innovative Finance ISA (IFSA)

This complex product includes peer-to-peer loans or buying up business debt. IFSAs match investors with borrowers who might struggle to get a traditional bank loan; accordingly, there are often higher potential returns on offer, but at the cost of much higher risk. In addition, many peer-to-peer loans aren't covered by FSCS protection.²

ISA savings are usually covered by the FSCS protection scheme, up to £85,000 per person per banking licence. Many investors choose to hold accounts with multiple providers to obtain the maximum possible protection if they go over this limit.

There are several further important points to consider:

• The Lifetime ISA is restrictive, but the 25% guaranteed bonus on savings is essentially unbeatable from a risk-reward perspective
• The power of compounding returns is hugely amplified in an ISA as returns aren't reduced by tax, and this effect becomes more apparent over time
• Investing-based taxes have been slowly rising for some time. This makes an ISA ever more attractive, as tax savings are correspondingly magnified
• The government reserves the right to amend ISAs at any time. There are ongoing campaigns to simplify ISAs into one account type, to reduce the amount that can be saved, and even to only allow investing in UK-based companies to help boost domestic growth
• ISAs are extremely generous by international standards, given their tax efficiency and flexibility. In most other countries, you can pick one benefit or the other
• Unlike a SIPP, your ISA allowance functions on a 'use-it-or-lose-it' basis. Your allowance resets with the beginning of the new tax year

What is a savings account?

A savings account is very simply an account into which you pay money, and this money then earns you interest. You can gain varying degrees of return depending on the account's terms, limits and restrictions. As a general rule, the longer you lock your money away and the more restrictive the withdrawals, the higher the interest rate.

There are three key savings account types in the UK:

Notice Savings Accounts

These accounts allow you to make a withdrawal after a set notice period. Interest rates are typically more competitive than within an easy-access account.

Easy Access Savings Accounts

These give you the flexibility to deposit and withdraw your cash when you wish.

Fixed Rate Bonds

These provide guaranteed returns over a set term on a lump sum deposit. The term usually lasts up to five years, and bonds often offer a much higher rate of interest than other savings account types. However, the money is 'locked away', so you might miss out if better offers become available or on potentially better returns on equities over the longer term.

As with ISAs, your deposit and interest earned are protected up to £85,000 per person per banking group, assuming the institution offering the savings account is regulated and based in the UK.

Opening a savings account is usually worth it if you have short-term goals – for example, if you plan to use your money as a house deposit in the near future. However, if you have a long-term goal, investing in a stocks and shares ISA may be preferable, as equities tend to outperform cash over time.

What is the difference between an ISA and an ordinary savings account?

There are many differences between an ISA and a standard savings account, many of which will be specific to the exact accounts being compared. However, some general rules include:

Tax

The key difference between ISAs and savings accounts is that you won't be taxed on savings you have in an ISA up to £20,000 per year – which covers most investors.* With a savings account, you can earn interest of up to £1,000 tax-free if you're a basic rate taxpayer, or up to £500 tax-free if you're a higher rate taxpayer.

It's worth noting that returns in a savings account are usually higher than those in a cash ISA, so if you're unlikely to be liable to pay tax on the interest generated, it makes more sense to invest in a savings account. Further, it can be more advantageous to invest in shares in your ISA to benefit from tax-free returns, rather than in cash where the tax savings will usually be smaller.

In addition, your spouse or civil partner can inherit your ISA balance completely tax-free, a benefit not found with savings accounts. This offers tax planning benefits.

Deposit limits

You can only deposit up to £20,000 per year into your ISA accounts and can only pay into one of each type of ISA account per year. Savings accounts have no deposit limits and no restriction on how many accounts you can open. This means if you have an easy-access account open and a competitor then offers a better interest rate, you can change the account without penalty.

Ease of access

When you open as ISA, you can take your money out at any time, but not all ISAs are made equal. If you withdraw your money from some ISAs, the money withdrawn will still count towards your annual allowance. We offer flexible ISAs, which allow you to withdraw money without affecting your allowance, meaning you can redeposit at a later time. Only easy-access savings accounts are as flexible.

There's one exception – the Lifetime ISA. Unauthorised withdrawals – for anything other than a first home or when you turn 60 – are charged at 25%, which is more than the 25% government top-up.³

For example, if you deposited £800, the government would top you up by 25% (£200) to £1,000. If you then withdrew the £1,000, the government would charge you 25% (£250), leaving you with £750 – £50 less than you started with.

Would-be LISA investors should therefore balance the very advantageous bonus with this little-known drawback. And there are further restrictions – the property must be bought with a mortgage, cost £450,000 or less, and be bought at least 12 months after your first deposit.

Risk factors

Stocks and shares ISAs rely on companies held to deliver returns, but returns aren't guaranteed even with the most conservative ETF-based portfolio. Remember that past performance doesn't guarantee future returns, and your risk is capped at the cost of opening the position when investing.

Meanwhile, innovative finance ISAs are high-risk, high-reward by nature.

When comparing cash ISA and savings accounts, both have no risk of capital loss. But, if your interest rate is below the rate of inflation (a common scenario), then the real terms spending power of your cash will be eroded over time. Equities tend to keep up with inflation much better, but they also come with higher risk.

Deciding between the different accounts depends on many factors, including your personal risk tolerance, age until retirement, funds available and expected future earnings. Many investors split their capital between multiple different accounts.

How to invest in an ISA with us

You can either select your own investments in a share dealing ISA, or you can open an IG Smart Portfolio ISA.

IG Share Dealing ISA

This account functions like our typical share dealing account, but with the tax benefits associated with an ISA.* You pick your own investments, and profits and losses are dependent on your investing choices.

1. Learn more about ISA accounts
2. Open a share dealing ISA account with us
3. Select your shares
4. Choose your position size and manage your risk

IG Smart Portfolio ISA

This ISA option leaves you with a fully managed, diversified and tax-efficient investment portfolio.* Competitive fees apply, and we're fully transparent with historical returns.

1. Learn more about ISA accounts
2. Open a Smart Portfolio ISA account with us
3. We'll help you find an ISA that's right for your risk profile.
4. Activate your chosen Smart Portfolio ISA

New to investing or trading? Build your confidence by practising on a demo account.

ISA vs savings account summed-up

• An ISA is a popular vehicle that offers extremely advantageous tax-free benefits. Returns are free of income tax, capital gains tax, or dividend tax*
• There are four key types of ISAs, each with its own set of advantages and drawbacks
• Opening a savings account is usually worth it if you have short-term goals
• You can only deposit up to £20,000 per year into your ISA accounts and can only pay into one of each type of ISA account per year
• Both cash ISAs and savings accounts have no risk of capital loss, but if your interest rate is below the rate of inflation then the real terms spending power of your cash will be eroded over time

*Tax laws are subject to change and depend on individual circumstances. Tax law may differ in a jurisdiction other than the UK.

¹ ISA or savings account? – Raisin
² ISA or Savings Account – HSBC UK
³ Individual Savings Accounts (ISAs) Overview – GOV.UK