By David Prosser
Will she or won’t she? For months, the Westminster rumour mill suggested Rachel Reeves planned to reduce the amount of money that people can put into cash individual savings accounts (ISAs); however, the Chancellor apparently changed her mind this summer. You’re still entitled to put up to £20,000 into a cash ISAs each tax year – the same limit as applies to most investment ISAs.
Many savers will be delighted. Cash ISAs are straightforward products – they’re bank or building society savings accounts with protection from the taxman built in. Every penny of interest you earn on money placed inside a cash ISAs is tax-free. For example, one of United Trust Bank’s top-paying cash ISAs currently offers a 3-year fixed interest rate of 4.21% a year; on the full £20,000 allowance, that’s £842 of interest with no tax to pay.
It’s worth saying that the reprieve may be temporary. Ms Reeves has consistently argued that it makes sense to encourage savers in the UK to put more of their money into UK companies striving to invest and grow. She thinks that limiting the cash ISA allowance might prompt people to put more money into a stocks and shares ISA, with some of this money going into those companies.
Nevertheless, cash ISAs remain, for now, unscathed. This is a good opportunity to think about where and how you’re saving – to ensure you’re making the best use of all the savings allowances available. That includes cash ISAs, but also other schemes.
How ISAs work
Cash ISAs are part of the broader ISA system. All adults in the UK are entitled to their own ISA allowance, enabling them to save and invest up to £20,000 over the course of each tax year (running from 6 April to the following 5 April). You can use all of that allowance in one type of ISA, or spread your money across different types of ISAs, potentially with different providers.
Cash ISAs are the simplest ISAs option. They’re available from a wide range of banks and building societies. Some accounts pay variable rates while others offer fixed rates of interest. The most generous cash Isas may require you to lock your money up for a set period, but there are also plenty of easy and instant access options available.
Critically, all the interest you receive in a cash ISA is tax-free. There’s no need to declare the money on a self-assessment tax return and there is no tax to pay on the interest whatever income tax rate you normally pay. That’s true in the year you earn the money and every year thereafter; all money held in a cash ISA is tax-free forever. Over time, as people pay into cash ISAs year after year, this can add up to a very significant saving.
In recent years, some personal finance analysts have questioned the value of cash ISAs, pointing out that since interest rates have been so low, savers were paying very little tax on their interest even outside of a tax-free account. It’s a point worth considering, especially since other types of ISA’s have the potential, at least over the longer term, to deliver higher returns. But interest rates can – and do – change regularly. Rates are now considerably higher than they were just three years ago; that makes cash ISAs more valuable.
Other tax-free savings allowances
Nevertheless, it’s important to understand that beyond cash ISAs, you may still have access to tax-free savings; this can help you decide how to arrange your finances.
In particular, the personal savings allowance (PSA) is a tax-free allowance that enables most people to earn some savings interest with no tax to pay. The PSA varies according to the rate of income tax you currently pay:
• Basic-rate (20%) taxpayers can earn up to £1,000 in savings interest each year with no tax to pay.
• Higher-rate (40%) taxpayers can earn up to £500 in savings interest each year with no tax to pay.
• Additional-rate (45%) taxpayers do not get an allowance.
For the purposes of the PSA, savings interest is defined as any interest you earn from savings accounts at banks, building societies and other providers, as well as from credit union accounts, trust funds, peer to peer lending and some life insurance contracts. Income paid by government bonds (gilts) and corporate bonds issued by companies also counts . Interest earned on Trust Funds, peer-to-peer lending and some life insurance contracts are also subject to allowance limits.
It’s worth doing some sums here. For example, United Trust Bank’s Easy Access account currently pays 4.00% interest a year. So, if that’s your only savings account and you’re a basic-rate taxpayer, you would need to have a balance of £25,000 before tax is due; the equivalent figure for a higher-rate taxpayer is £12,500.
The exact figures will change as interest rates move up and down, but you can see the point. If you’re managing a smaller pot of savings cash, it may make sense to use your PSA before you start considering a cash ISA. That said, bear in mind that governments regularly change tax rules and allowances; your own circumstances might also change – you could move into a higher income tax bracket, say. One virtue of cash ISAs is their simplicity; you don’t have to worry about calculating if and when you might need to start paying tax.
One other allowance to consider is the “starting savings rate”. This is only available if you earn less than £17,570 in the current tax year; if so, it enables you to earn up to £5,000 in savings interest completely tax-free. The amount of interest you can earn tax free reduces by £1 for every £1 you earn above your personal income tax allowance from other sources, such as a pension, salary or other savings or investment income. For example, if your income is £15,000, your starting savings rate allowance is £17,570 minus your £15,000 income. So, in the current tax year you could earn up to £2,570 in interest without paying tax on it. This is in addition to your personal savings allowance.
Make the most of your savings pot
Everyone should have some cash in a savings pot. This is money you can draw on in the case of an emergency – three to six months’ worth of income is a good target to aim for. In addition, savings accounts are great places to park cash that you have earmarked for a particular use in the future – to pay for holidays in the year ahead, say, to fund home improvements, or to buy a new car.
Make sure you’re getting the best possible deal on your savings by shopping around between banks and building societies for competitive rates of interest; don’t be afraid to move provider to secure extra interest. And think about how to minimise the tax you pay in your savings interest, particularly through the PSA and cash ISAs.
That said, savings accounts aren’t right for every financial planning need. If you’re putting money aside for long-term objectives – retirement, for example – it’s worth exploring investments that might deliver superior returns. These can be tax-efficient too, thanks to stocks and shares ISAs and private pensions. Take professional independent financial advice if you’re not sure what’s right for you.
David Prosser is a freelance journalist and personal finance expert
This article isn’t personal advice. If you are not sure how to manage your savings, please seek advice from a professional Independent Financial Adviser.