Most of us are familiar with three types of Isa: cash, stocks and shares and junior Isa.
But did you know that there are three other types, each with different rules and risks?
One helps those under 40 save for a home; another is to invest in loan companies; and the third is to buy the smallest stock market shares and pocket a potential inheritance tax avoidance benefit.
It’s not easy to determine if these alternative Isas are right for you. Here is a practical guide to help you.
Is it good for us? Think carefully if a Lifetime Isa will meet your needs
Lifetime Isa – for a 25% increase in security deposit
Launched almost six years ago, a Lifetime Isa can be opened by people aged 18 or over, but under 40.
You can deposit up to £4,000 per tax year and earn a 25% government bonus up to a maximum of £1,000 per year.
The £4,000 counts towards your annual Isa allowance of £20,000. You can save in one cash and one stock and Isa stock next to the account if you want.
However, there are strict rules on how you can spend the money you save.
- You can use it to buy your first home, but it can’t cost more than £450,000
- Or you can leave the pot untouched until you’re 60
- And you can only contribute up to 50
- There is a huge penalty if you break these rules
Withdraw the money before age 60 for anything other than a house and you’ll be hit with a 25% charge. This wipes out the government bonus and eats away at what you’ve saved.
For example, out of a £10,000 pot, £8,000 would come from your own contributions and £2,000 from the government bonus (assuming no interest or growth).
A 25% penalty would mean losing £2,500, so the government bonus plus £500 of your own savings.
A handful of providers offer lifetime Isas, but none of the major banks do. The best rate is 3.5% from digital company Moneybox. You can also opt for a shares and shares version.
VERDICT: The 25% bonus is attractive if you’re saving for your first home. But you need to be sure you’ll use it for that – or, alternatively, you can wait up to 60 years to access the funds. Otherwise, the penalty is so high that it is better to use an ordinary Isa or pension.
Innovative Finance Isa – for peer-to-peer investing
There is an Isa dedicated to savers who wish to invest in so-called peer-to-peer (P2P) loans.
Companies like RateSetter and Funding Circle take savings from customers and lend the money to individuals or businesses.
There are some similarities to banks, but P2P companies are more lenders than lenders themselves. And they don’t have the huge overhead costs of a bank.
The idea is that savers and borrowers get better rates by cutting out banking intermediaries.
Option: Companies like RateSetter and Funding Circle take savings from customers and lend money to individuals or businesses
P2P loans have been around for over 15 years, and you’ve been able to save using tax-free Isa packaging since 2016.
However, the adoption of Innovative Financing Isas (IF Isas) has been moderate. This is partly because P2P lending is riskier than hiding money in a cash Isa. You can lose your principal if a borrower fails to pay or repay their loan. Also, your savings are not protected by the Financial Services Compensation Scheme, which covers bank deposits up to £85,000.
Some companies offer up to 9% return, but beware, the higher the risk, the higher the rate.
Some IF Isa providers have gone bankrupt in the past. And industry leader Zopa pulled out of peer-to-peer lending altogether at the end of 2021 to focus on banking.
VERDICT: Do your homework if you’re tempted. Treat this as an investment where there is a risk that you will lose all your capital. Ideal for more experienced investors who are happy to experiment with part of their portfolio.
Aim Isa – for IHT planning
This is a specialized Isa that can only hold shares listed on the Alternative Investment Market (Aim).
Often referred to as Britain’s ‘junior’ stock market, Aim is home to thousands of fast-growing technology, healthcare and environmental companies.
Success stories include tonic maker Fever-Tree, holiday package seller Jet2 and video game support company Keywords Studios, each now worth over £1billion.
It’s essentially a modification of the standard Isa shares and shares and you get the same rules on the £20,000 tax-free Isa allowance and the benefits of tax-free income and growth, but the shares Aim eligible eligible for inheritance tax relief.
After two years of holding the shares, you should be able to pass them on without incurring inheritance tax (IHT).
The tradeoff is that publicly traded companies are risky, with no guarantee of success; many fail.
But if you use Aim Isas for tax planning, the value of the portfolio would have to drop 40% more than other investments to negate the benefits of IHT.
You can choose your own stocks or a ready-made selection managed by an Aim Isa specialist such as Octopus, through a financial advisor or broker such as Wealth Club.
Please note that not all Aim companies are eligible for benefits without IHT.
VERDICT: For sophisticated investors only. Speak to a financial advisor to determine if this type of account is right for you.
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