If you want to keep all the interest from your savings then a Cash ISA is the account for you, here’s a beginner’s guide to help you choose the best tax free home for your money.
Getting the best return on your savings is not only satisfying but also makes financial sense. Making sure you protect your savings from the taxman is a great start and an ISA does just that.
Here’s everything you need to know about Cash ISAs and how exactly you can pick the best one for your circumstances.
What is a Cash ISA?
A Cash ISA is a savings account like any other but with one major difference.
Unlike ordinary savings accounts you don’t pay tax on the interest you earn.
If you’re a tax payer with money in a standard savings account you will have income tax deducted from the total interest you earn before it’s credited to your account. This ‘net’ rate of interest will be less than the advertised AER rate.
However money in a Cash ISA (Individual Savings Account) is protected from income tax so you receive the full AER/gross interest rate advertised, without having tax deducted.
Who can have one?
ISAs cannot be held in joint names or on behalf of anyone else as they are individual savings allowances.
However, anyone over the age of 16 who is resident in the UK can open a Cash ISA. Crown Employees such as soldiers and diplomats who live overseas and their families are also eligible.
A new Junior ISA scheme was launched in November 2011 following the Coalition government’s Spending Review.
However, Junior ISAs are significantly different from standard Cash ISAs and are designed as a replacement of the outgoing Child Trust Funds - for more information read our guide Junior ISA Regulations FAQs.
Cash ISA limits
You can only pay into one Cash ISA each financial year (6th April – 5th April) due to the tax benefits you receive.
There is also a limit to how much you can save in a Cash ISA in each financial year: For the 2011/12 tax year the limit is set at £5,340.
This actually only represents half of your tax free savings allowance, in total you can save up to £10,680 in an ISA, but the rest must be through an Investment ISA.
Read our Beginner's guide to Investment ISAs for more information.
Can you access your money?
You will often be able to secure a better interest rate if you lock your money away in a Cash ISA for a fixed period or choose an account that requires a certain notice period for you to access your money.
Fixed rate Cash ISAs can guarantee the rate of interest you’ll earn for up to 5 years, however there are a couple of things to consider before tying your money up.
Firstly, it’s unlikely that you’ll be allowed to draw on your money during the fixed rate term. Some accounts don’t allow any access, while others are likely to penalise you for the privilege. As such you should only opt for a fixed rate Cash ISA if you are confident you won’t need to draw on your savings. Similarly, if you do decide to fix, you should consider how long you can afford to leave your money untouched.
Secondly you need to consider how interest rates are likely to perform during any fixed rate period. This is particularly the case if you lock in to a long term fixed rate Cash ISA account.
While the initial rate may look attractive compared to an instant access account, if savings rates climb during your fixed term period you could end up losing out. Of course, the same also applies – if interest rates fall, the rate paid on your savings will seem favourable.
If you decide that you may need to get hold of your money at short notice, an instant access Cash ISA is likely to be the best choice.
The vast majority allow you to withdraw your cash without notice or penalty. There are, however, a few instant access savings accounts that apply limits to your access so you need to check the terms and conditions. You can use our Instant Access Cash ISA comparison table to find out what’s on offer and compare features and benefits.
How much do you have to save?
The way you save is also likely to have an influence on which account is the best choice.
If you have a lump sum that you need to deposit immediately your needs will vary from someone who wants to save £50 a month.
If you want more flexibility then an instant access Cash ISA will allow you to pay in up to your annual £5,340 ISA limit as and when you like. You will also be able to withdraw your money when you need it without having to worry about losing interest or having to give notice.
Fixed rate ISAs are often targeted at savers who can deposit a lum sum and leave it untouched for a fixed period. They will tend to guarantee a rate of interest for a set number of years.
Some Cash ISAs, usually dubbed Regular Saver ISAs, are specifically targeted at people who want to save on a monthly basis. However remember that even though the rate may look more attractive than some standard accounts, you won’t have a full balance earning interest until the final month.
How much interest can you earn?
The main factor which will decide how much your money makes is the interest rate you are offered and as a rule the higher the rate the better.
Once you’ve decided how you want to save in a Cash ISA, and whether you would prefer a fixed rate or instant access account, you should try and find the Cash ISA that offers the highest interest rate possible on the amount you want to save.
You may also want to compare the rates offered by standard savings accounts to the Cash ISAs, however remember to use the net rate from the standard accounts to include the tax you’d pay.
If you’re a basic tax payer you’ll get 20% less, 40% less if you’re a higher rate tax payer and 50% if you fall into the top rate tax bracket.
Can you transfer balances from old ISAs?
If you have Cash ISAs from previous year’s it makes sense to check the rate of interest you are earning on them.
Some Cash ISAs will guarantee an attractive rate for a fixed period (often 12 months from account opening) and will then automatically switch to a much lower interest rate.
Others entice savers in with an introductory bonus but can fluctuate from the very first month.
It makes sense to make a note of when your interest bonuses end and check your interest rates on a regular basis to make sure you’re not missing out.
If you find that you are earning a poor interest rate on your Cash ISA then look for a new account that accepts ISA transfers.
Don’t simply withdraw the cash, instead you should contact your bank to arrange an ISA transfer, this way you can move your ISA savings without losing your tax free protection.
Unfortunately under current rules you cannot transfer money held in an Investment ISA into a Cash ISA, although you can transfer balances held in Cash ISAs into Investment ISAs.
Do I have any other options?
If you are left feeling uninspired by the interest rates on offer from the Cash ISAs on the market then you may want to consider looking into an Investment ISA.
Your Cash ISA allowance only represents half of your annual entitlement, the rest can be invested in stocks and shares through an Investment ISA.
Try following our Action Plan How to start investing in shares for more help.
Are you better off using your money elsewhere?
Although saving up for a rainy day, or simply trying to get a good return on your money is a good idea, there are occasions where your money could be put to better use elsewhere.
If you have any outstanding debts then it’s likely that what you’re charged in interest would far out-weigh the money you’d earn in even the highest rate ISA.
For example an outstanding balance of £1,000 on a low interest credit card with an APR of 16.9% would cost you approx £169 in interest charges, while the same balance in a generous 5% ISA would only earn £50 – less than a third - over the course of a year.
Therefore clearing any debts before saving into a Cash ISA, or any type of savings account, is likely to save you money in the long run.
For more information read our guide Should I Use My Savings to Pay Off My Debts?
