Why you should choose a stocks and shares ISA over a cash ISA?

What is a stocks and shares ISA and how does it differ from a cash ISA? Aren’t they both used to invest money?

What is a stocks and shares ISA?

A stocks and shares ISA is a product that invests your money rather than storing it as cash. Most stocks and shares ISAs allow you to select your investments, which include a range of stocks, commodities, as well as mutual funds, investment trusts and government bonds.

You don’t need to be a city trader or a hedge fund manager to open a stocks and shares ISA. In fact, there are only two requirements:

• You need to be aged 18 or over
• UK resident for tax purposes

It’s entirely up to you what to do with any income generated from a stocks and shares ISA. It can be reinvested and kept in your account, withdrawn as a profit or held and moved into a cash ISA. However, you may incur a transfer out fee for moving your stocks and shares ISA gains to an account with another provider.

Pros and cons of stocks and shares ISAs

Pros

• Tax benefits
  Any gains incurred as part of a stocks and shares ISA are not liable for capital gains tax making it a tax-efficient form of investing. Although investors in equities currently receive a dividend allowance of £2,000 per annum, any profits above this are subject to income tax.
   
• Historically stronger returns than cash ISAs
  The performance of a stocks and shares ISA is intrinsically linked to the stock market. Whether you’re investing in equities, commodities or indices, the long-term returns of the markets have significantly outpaced the rate of return from cash ISAs since the early 1990s.
   
• Fully transferrable
  If you’re ever disappointed with the general performance or management of your stocks and shares ISA, you can always transfer it to another provider. 
  
  
• Great range of assets to invest in
  Although it’s called a stocks and shares ISA, the reality is that you can invest in so much more than just equities. You can invest in everything from government and corporate bonds to ETFs and investment trusts if you wish.

Cons

• No guarantee of profits
  Stocks and shares ISAs are not without risk. In fact, they are significantly riskier than cash ISAs. Your investments can fall as quickly as they can rise. However, if you take a long-term view of your investments, it is possible to ride out the downswings and market turbulence.
  
  
• Account charges can eat into your gains
  If you choose a stocks and shares ISA where your provider actively manages your funds and any subsequent investment decisions, you will incur management fees.. This can eat into your profits, depending on how much your investments have returned through the year.

What is a cash ISA?

A cash ISA operates in similar vein to a basic savings account, with one key exception – you do not incur tax on the interest earned.

Cash ISA tax allowance

Cash ISAs are widely available with most high-street banks and building societies, as well as major online-only and supermarket banks.There are different types of cash ISAs to choose from. For example, there are ‘easy access’ cash ISAs, which offer the lowest rates of interest to enable you to access your funds almost instantly at no cost. There are also fixed-rate cash ISAs, which pay a fixed rate of interest for a predetermined period. For example, you might be offered a rate of 2% for an initial two years.

It's only possible to open one cash ISA per tax year. However, you can open   a stocks and shares ISA in the same tax year, but you can only invest a maximum of £20,000 across both accounts in the tax year. It’s safe to deposit funds into a cash ISA, providing you choose an account provider that’s authorised and regulated by the Financial Conduct Authority (FCA). This will ensure your funds are guaranteed and protected up to £85,000 as per the terms of the Financial Services Compensation Scheme (FSCS).

Cash ISAs are open to anyone aged 16 or older.

Pros and cons of cash ISAs

Pros

• Low-risk savings
  Cash ISAs are considered less risky than stocks and shares ISAs because there is no danger of you losing money. You continue to accrue interest, although in recent decades interest rates have historically been much lower than the rates of return from the stock markets.
   
• Instant access accounts are available
  It’s possible to use a cash ISA as a ‘rainy day’ fund. If you want to ring-fence some cash away from your current account and ensure you have enough money saved to cover your next major purchase, this could work well. You can choose an easy access cash ISA that gives you same-day access to your funds. Although the immediacy of access means that most banks will give you a reduced interest rate for the privilege.
   
• Fully transferrable
  If you find a provider offering a more competitive interest rate, it is possible to transfer your initial cash ISA to a new provider. However, you must request to transfer the funds to ensure your savings remain tax-free. If you withdraw the funds yourself and move them into a separate cash ISA, your tax-free status is lost.

Cons

• Can struggle to keep pace with inflation
  If you opt for an easy access cash ISA with relatively low rates of interest offered, you could find that your savings are unable to keep up with inflation. If your interest rate is below the current rate of inflation, your savings are worth less in real terms, as living costs rise. 
• Modest returns likely
  Although cash ISAs are popular as a low-risk way to save for a rainy day, they typically guarantee only modest returns. With interest rates at historic lows, it’s hard for cash ISAs to even come close to outperforming the stock markets at present.
   
• Teaser interest rates can be deceiving
  Be mindful that some cash ISA providers may promote attractive introductory interest rates to entice you to sign up. However, these introductory rates only last for a short period before falling to a base level.

When is a stocks and shares ISA a better option than a cash ISA?

The decision to choose a stocks and shares ISA over a cash ISA depends on the answer to one key question - how long do you intend to save for? If you consider yourself a long-term investor of five years or more, it's prudent to invest using a stocks and shares ISA.

Investing your savings rather than holding it as cash and accepting the interest is proven to yield stronger returns over time. Historically, stock markets have outpaced inflation and the subsequent interest rates of cash ISAs.

Between 1926 and 2017, the S&P 500 Index reveals an annualised return of 10.22% - that's almost a four-fold improvement on the 2.89% average inflation rate during the same period. The other danger for cash ISA investors are interest rates sitting significantly below inflation. eroding the broad-based spending power of cash ISA savings.

Although inflation surging above interest rates has certainly eroded the value of money of cash ISA savers in real terms, it’s no indication of future performance. Although we can use past data to compare returns and how stocks and shares ISAs have outperformed interest rates long term, we cannot predict how the financial markets will fare in ten years’ time. The very nature of investing in the stock market means that investments can fall as well as rise.

If you are genuinely saving for the long-term - such as your retirement - a stocks and shares ISA is likely to be the sensible choice if you can afford to ring-fence funds for several years.

Of course, once you are ready to open an ISA account, nothing is stopping you from opening both a cash ISA and a stocks and shares ISA simultaneously. This allows you to take your short- and long-term finances into account.

Remember, there is a maximum ISA allowance per annum of £20,000, which can be spread across both accounts or within one ISA account if you wish.