Why I don’t put my money in a Cash ISA.
When my friends talk to me about savings, they always mention ISAs. It’s where they’ve always been told to save their cash (though they don’t quite understand why), and they’ve dutifully stashed as much of their savings in one as they could. But I don’t have one. I haven’t had one for close to six years.
The whole point of an ISA (or Individual Savings Account) is that any interest you earn is tax-free. So if you had £5,000 earning 3%, you’d get to keep all of the £150 you’d make, rather than lose 20% or 40% to the taxman. So logically, a lower rate ISA could be better than a higher paying standard savings account.
But in reality for the last few years the legitimate tax loophole provided by an ISA has made sod all difference for most people.
In part it’s down to really poor interest rates. Before the crash in 2007, the average rate of interest for a Cash ISA was more than 5%. Nice! The best rate today for an easy access Cash ISA (where you can access your money whenever you want) is a pretty rubbish 1.45%. And that’s the highest it’s got for years.
But the main reason I haven’t had an ISA, and why you probably don’t need one either, is down to a rule change from a few years ago.
You can earn tax-free interest without an ISA
In April 2016 the Personal Savings Allowance (PSA) was introduced to give pretty much everyone tax-free interest on savings from any source, not just ISAs. In fact, any earnings in an ISA don’t count towards your PSA.
The PSA works like this. If you are a zero or basic rate taxpayer (essentially you earn under £46,351, or less than £50,001 from April 2019), you can make £1,000 in interest in a year before you start paying tax on it. That’s a huge amount.
If you earn a little more and pay 40% tax, then you still get an allowance, but it’s reduced to £500 a year.
So with a 1.5% easy access savings account (the best rate available in one at the moment), you’d get £7.50 interest tax-free for every £500 saved. To put it in perspective, that means you’ll need £33,333 before you hit £500 in interest, and £66,667 before you’d reach the full £1,000 PSA.
Better paying alternatives to Cash ISAs
So if you don’t need an ISA to earn tax-free interest, what should you be doing with your savings?
I wrote a few weeks ago about the highest paying cash savings options such as specific current accounts and regular saver accounts. It’s in these accounts that I put my money and I get an above-inflation average return – possibly up to a huge 5%. You can also look at app only accounts such as Chip. There’s more information on each of these in the same article.
If you do take advantage of these and have a decent amount of money saved you could approach the PSA limit faster – but it’s still unlikely to affect most basic rate taxpayers.
That’s because most of the accounts will have limits on how much you can earn interest on. Say you have £1,500 at TSB earning 5%, that’s £75. Putting £300 a month into First Direct’s Regular Saver will net you close to £100 after 12 months. Far better returns, but still some way of £1,000.
What if you earn more than the Personal Savings Allowance?
Of course you might earn more than the PSA if you have multiple high earning current accounts and regular savers – especially if your’s has been lowered to £500. Or you might just have a huge stack of cash. As I said earlier, £67,000 earning 1.5% will earn you more than £1,000 over 12 months.
So what then? Well, you’ll want to get a… Cash ISA. Okay, okay. I know I’ve just written 600 words saying don’t bother with Cash ISAs.
Let’s say you’ve maxed out your PSA with that 1.5% account. Every extra £1 of interest you earn will now be taxed at 20% or 40%, bringing the real rate down to 1.2% or 0.9% respectively.
Now as long as you can beat that rate with an ISA – which you currently can – then the tax-free part of an ISA does make a difference, making an ISA the best home for your additional savings. Though bear in mind there’s an annual limit of £20,000 that can be paid in to an ISA each financial year.
And if you’re likely to have a fair bit of cash saved every year, another feature in favour of ISAs is that they keep earning tax-free interest year after year. This could help in future years if interest rates were to rise or if the PSA was to shrink. Higher rates would mean the PSA tax-free limit would be reached sooner, especially if you’re a higher rate taxpayer, so having some cash in an ISA could boost tax-free returns.
Alternatives to cash savings and ISAs
The above is all focused on easy-access cash ISAs and savings accounts. But there are alternatives if you don’t mind locking money away or are happy to risk the money as an investment.
First, fixing. There are Cash ISAs and savings accounts where you can lock money away for multiple years. This means you can’t withdraw the money for the set duration unless you’re prepared to forfeit the interest earned or pay a penalty. But rates can be higher if you do
And if you’re willing to leave your money locked away for at least five years or more, then a Stocks and Shares ISA could be for you. The thing to remember is there’s also the risk you could lose some of your savings if your investments don’t work out well. Though if they do, the return could be much higher than elsewhere.
If you’re a first-time home buyer or self-employed then there is an ISA which could be good for you. I’ve written about the Lifetime ISA, or LISA, before, so take a look at that article for more information. But in essence, you’ll get a 25% bonus, to a maximum of £1,000 a year, towards either your first home or retirement. There are pros and cons, but free money is free money right? The Help-to-Buy ISA works in a similar way, but just for buying a home.
Of course, you don’t have to save all your money. Personally, I’d always try to keep an emergency buffer of cash savings, but if you have any debts, it makes sense to clear them first, particularly while interest rates are low. You might also be better off overpaying your mortgage (if you’re allowed to).