With interest rates on savings at an all-time low would you be better off saving in a tax-free ISA or in a standard savings account? We weigh up your options.
At a time when interest rates are so low, it can be difficult to know where to save your money in order to maximise its potential. If you opt to save in a market-leading savings account you can make your savings work as hard as they can in the current climate, but as any interest earned will be taxed you could be left with less than you’d bargained for.
Any interest earned on savings in a standard savings account will be taxed by 20% if you’re a basic rate taxpayer, and 40% or even 50% if you’re a higher rate taxpayer, meaning a significant slice of your interest will go to the taxman.
If you decide to save in a Cash ISA you’ll benefit from tax-free interest on your savings, but as ISA rates can be lower than the market leading rates available on standard savings accounts, your gross interest may still be less than the net interest from a taxable savings account. To help you decide where to save your money, we look at the benefits and drawbacks associated with these 2 different savings accounts.
Why save in an ISA?
You may consider saving your money in an ISA because of the obvious tax benefits involved. Any saved funds up to a limit of £5,340 per tax year (increased from £5,100 in April 2011) will be paid interest completely free of tax, which makes ISAs an attractive alternative to standard savings accounts.
Though the interest rates on ISAs tend not to appear very competitive when compared at face value with a standard savings account, the bonus of enjoying gross interest rather than net can make the return on your money equal to or even greater than that received on a savings account where interest is taxed.
Why save in a standard savings account?
Depending on the market, saving in the highest rate savings account available can give you a competitive return on your money, which is the main reason you may want to save in a standard savings account.
However if you decide to stash your money in one of these accounts it’s important first to work out how much interest you will be earning after tax. This involves looking at the net amount of interest you will earn after tax, rather than the gross value. If what you’re left with is less than the best return available from an ISA, you’ll be better off saving your money in an ISA for the time being and preventing the tax-man from getting a cut of your interest.
What else would help my decision?
You are only able to save a maximum of £5,340 in a cash ISA each tax year (running from 6th April one year to 5th April the next). What’s more, you’re unable to carry over ISA allowances from one year to the next, meaning that if you don’t use up your allowance this year, you’ll lose it and won’t be able to add it on to next year’s allowance.
Many savings accounts have variable rates, meaning they can drop at any time and leave you with a less competitive return on your savings than you’d expected. However, though rates may drop dramatically, ISAs will always keep your savings tax-free. This means you will always have the reassurance of knowing you’ll at least be earning gross interest on your saved funds in an ISA. On the other hand money saved in a taxable account will only earn net interest, which could turn out to be a very poor return if rates have dropped.
What’s more, if the rate plummets on savings you have in an ISA, you can always transfer your tax-free cash to a new tax-free wrapper with a better rate if you wish. However remember that if you withdraw money from an ISA it will lose its tax-free status, so always transfer rather than withdraw if you want to switch your ISA home.
What else should I consider?
As the rates on ISAs tend to peak towards the start and end of the tax year, you may want to postpone filling your ISA allowance in the hope that you’ll be able to get a better rate in March or April than you can in the middle of the tax year. In this case you may want to keep your savings ticking over in a high-interest savings account until a more competitive ISA product becomes available, and only then move your savings to take advantage of your ISA allowance.
If you decide to do this however, make sure that you are able to transfer your savings when the time comes. If you choose a high-interest account it may come with restrictions on when and how you can withdraw your money, meaning it may not be possible to move it to fill up your ISA allowance when you want to. For this reason it’s important to check the small print before you settle on an account.
In addition it's important to make sure the return you'd be getting on money in a standard savings account while you're waiting for a better ISA rate is more profitable than the best ISA rate available, or there won't be any point postponing opening an ISA account.
Any money you put in an ISA now will remain tax-free indefinitely, a benefit that you will have to weigh up against opting for the best possible return on your money in the short term by putting it in a high-interest savings account. Whether you have a little to save or a lot, protecting your money by putting it in an ISA will ensure that it is always protected from tax unless you decide to withdraw it.
It’s worth remembering that though ISAs will not always boast the market leading savings rates, by filling your allowance each tax year you are ensuring that another £5,340 of your money is getting a decent return and staying firmly out of the tax-man’s grasp, which can only be a good thing.
