How to cut your tax bill with an ISA

If someone has money in general savings or investment accounts, they could well be paying tax on any interest or returns on investments. 

However, if they used an Individual Savings Account (ISA) instead, they currently won’t have to pay any tax on interest or returns as their money grows, nor will there be any tax to pay when taking the money out (although, of course, these rules could always be subject to change in the future).  

“It’s now been 25 years since ISAs were first introduced and, in that time, they've been a real success with everyone from modest savers right up to the very wealthy,” explains Martin Stanley, Chartered Financial Planner at independent financial adviser Rowley Turton. 

They’re especially popular with older savers as well – according to HMRC’s most recent statistics, there were just over seven million ISA holders aged over 65, and they also held the most amount of money in those accounts compared to any other age group. 

ISAs come with a few rules and restrictions, and understanding these is the key to maximising the potential tax-saving benefits ISAs can deliver. 

How do ISAs work? 

“There are two main kinds: cash ISAs, which are mainly offered by banks and building societies, and stocks-and-shares ISAs, which are mainly offered by investment companies,” says Stanley. 

While there are a few other types of ISAs available, we’re going to be focusing on the two most popular. 

Cash ISAs work just like ordinary savings accounts, meaning savers can choose between instant access, notice accounts and fixed rates, and a stocks and shares ISA that lets them invest in individual share holdings or things like funds or investment trusts. 

Stanley adds, whichever of these they choose, the main advantage is they’re free of all personal tax. 

However, there are some drawbacks to ISAs that savers need to be aware of. It’s important to pay careful attention to the rules (and potential fees) on withdrawals and allowances. 

It’s a saver’s responsibility to make sure they don’t go over the £20,000 ISA limit each financial year, which can be harder to keep an eye on if they're paying into multiple accounts across different providers. 

If someone invests in a stocks and shares ISA, their money is at risk as the value of their investments can go up as well as down – an independent financial adviser can be a good move here for anyone that’s feeling unsure about investments and wants to understand more about how they work. 

How do the tax benefits work? 

So how substantial are the potential tax savings from ISAs? Well, it varies depending on the type of saving someone is doing. 

If they’re just saving cash, the tax bill is based on the amount of interest received, but if they're investing, things like Capital Gains Tax (CGT) and tax on dividends can also come into play. 

While savers do get allowances on the amount they can earn before tax, these have been shrinking in recent years, meaning the tax savings from ISAs become even greater. 

Tax on interest from savings 

If someone saves money in a cash savings account, they'll usually gain interest on the amount saved. As this is a form of income, it can be subject to income tax. 

Savers do get a personal savings allowance – the amount a person can earn each year in savings interest, free of income tax – but this has been kept at £1,000 for basic-rate taxpayers and £500 for higher-rate taxpayers since it was launched in 2016. 

This has become more of an issue recently, with rising interest rates resulting in higher returns on cash savings, with over six million accounts in the UK earning enough interest to trigger a tax bill.

“A higher-rate taxpayer with a savings account paying 5% in interest would need just £10,000 in cash savings to use up this £500 personal savings allowance – they would then probably be subject to tax on the interest they earn above this,” Rachael Griffin, tax and financial planning expert at Quilter, says.  

A basic-rate taxpayer with more than £20,000 in cash savings at a 5% interest rate could be liable to pay some level of income tax. 

If this money is held in a cash ISA, however, any interest savers make will be sheltered from tax, regardless of their income tax bracket.  

Capital Gains Tax 

Investors may encounter this tax if they sell their investments and make a profit.  

CGT on investment gains is charged at 18% for basic-rate taxpayers or 28% if they're on the higher or additional rate.  

Griffin points out that, as of the 2024/25 tax year, the annual CGT exemption has fallen from £6,000 to £3,000, meaning investment profits above this level can be subject to tax. 

However, if someone holds these investments in an ISA, any gains they make won’t be subject to tax whenever they're sold. 

Tax on dividends 

When a company makes a profit, it can give some of this back to shareholders in the form of a dividend – and as they’re a form of income, they too can be subject to income tax. 

The amount of tax paid on dividends is linked to the income tax band of the person who receives them – and the rate for basic rate taxpayers is, at the time of writing, 8.75%, rising to 33.75% for higher-rate taxpayers and peaks at 39.35% for those who pay the additional rate.   

The tax-free allowance on dividends from investments dropped from £1,000 to £500 in the 2024/25 tax year.

This means that dividends on non-ISA investments over £500 a year are subject to income tax but - again - any dividends received from shares held in an ISA won’t be subject to tax.