How to compare ISA and savings rates after tax

Should you pick a lower paying ISA over alternatives?

The simple rule with savings is to get the best rate you can. But that assumes you won’t pay any tax on your interest earned. If you do, the effective rate you’ll receive could be lower. Here’s how to work out what you’ll really receive.

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Tax on savings

There are a few ways to avoid paying tax on savings. The first is the Personal Savings Allowance (PSA), which is set at £1,000 a year for basic rate taxpayers and £500 for higher rate taxpayers. That’s generally enough for most savers, though additional rate taxpayers don’t get the PSA at all.

But earn above these thresholds and you’ll pay tax on the additional interest paid to you. So for example, if you are a higher rate taxpayer and have £13,000 saved at 4%, you’ll earn a total of £520 in interest. But only £500 will be covered by your allowance, so you’ll pay 40% tax on the extra £20, leaving you with a total of £512.

The table below shows a few more examples.

Interest earned	Tax on interest as basic rate taxpayer	Tax on interest as higher rate taxpayer	Tax on interest as additional rate taxpayer
£500	£0	£0	£225
£1,000	£0	£200	£450
£2,000	£200	£600	£900

The other main way to not pay tax is to save in a Cash ISA. Any interest you earn in an ISA is tax-free. The downside is these accounts often pay less.

So though it might seem logical to go for the account that pays more, and that’s true if you won’t go over your PSA,if you are paying tax on interest outside of this, then the lower paying ISA might actually be better.

How to compare ISA rates to non-ISA accounts

To find out which will pay you more, you need to work out what the real rate will be after the tax is deducted, and compare the two rates.

The quick way to work out which rate is better is to apply the following sum to the ISA rate. Look for the top paying ISA rate, and multiply it by:

• 1.25 if you’re a basic rate taxpayer
• 1.66 if you’re higher rate taxpayer
• 1.82 if you’re an additional rate taxpayer

What you’ll get is the equivalent rate of interest needed before tax is removed to match that ISA.

Actual ISA rate	4%	2%
What you need at 20% tax to match it outside of an ISA	5%	2.5%
What you need at 40% tax to match it outside of an ISA	6.64%	3.32%
What you need at 45% tax to match it outside of an ISA	7.28%	3.64%

As you can see, it’s going to be almost impossible for a higher or an additional rate tax payer to beat saving in an ISA based on those rates. And it’ll be pretty tough for basic rate taxpayers too.

This isn’t always the case though, and if rates continue to fall, the difference between the the ISA and required rate will get smaller., as shown by the 2% ISA example.

You can find all the latest rates across different account types in our best buys section of the website.

Should you actually use your ISA allowance for cash?

So in all our examples, an ISA actually pays a better rate once you’ve used your PSA. But it doesn’t mean you should or can be putting all your savings into one.

For a start, there’s an overall £20,000 allowance on new money that can be added to ISAs each financial year. Plus there are still rumours that the Government will be looking to reduce the Cash ISA allowance, perhaps to £10,000 a year. We’ll know more in late November.

For most this won’t be an issue as that’s a lot of money to save. But for those with large amounts to save, it could well be you’ll need to use a non-ISA and pay tax on some of your interest. So the sums above will help you calculate what your real return will be.

And it’s important to remember this limit is combined across all ISA types. if you are also using a different ISA, such as a Stocks & Shares ISA for investing, then there’s less you can put in cash.

And if you are investing, it probably makes more sense to use your ISA allowance for that. First, you will be looking longer term, and therefore potentially larger gains which you’ll want to protect within an ISA.

Calculating an interest rate after tax

If you are going to pay tax on some of your savings above those tax free allowances, you can use these figures to work out your effective rate. To do this you multiply the non-ISA rate by the following:

• 0.8 if you’re a basic rate taxpayer
• 0.6 if you’re higher rate taxpayer
• 0.55 if you’re an additional rate taxpayer

Savings rate before tax	5%
What you’ll actually get if 20% tax is deducted	4%
What you’ll actually get if 40% tax is deducted	3%
What you’ll actually get if 45% tax is deducted	2.75%

These real rates will help you decide if there are better ways to use your cash, such as investing in a General Investment account, adding to your pension or overpaying your mortgage.