Author: Anna Bowes | Co-Founder – Savings Champion
March 16th 2023
What is a cash ISA?
An Individual Savings Account (ISA) is a type of tax-free account that can be used to hold either cash or investments. Introduced in 1999, the annual ISA allowance has increased over the years, from £7,000 to its current level of £20,000. In the case of cash ISAs, until 2015 you were only able to shelter half the allowance – the rest had to be put into a stocks and shares ISA for those who wanted to fully use their allowance.
A cash ISA is simply a savings account where all interest earned is tax-free, which means that in theory you should be able to hang onto more of the return you are making on your cash.
Why did cash ISAs fall from grace?
Having been a go-to savings account for savers wanting to minimise the amount of tax they paid on their savings, and therefore maximise returns, things really started to change with the introduction of the Personal Savings Allowance in April 2016. This new allowance, introduced specifically for cash savers, was great news and meant that many savers would no longer pay tax on their savings interest, especially as interest rates were very low.
As a result of a lack of interest in the product, competition waned and rates started to become far less competitive, which meant that for pretty much the first time since inception, the amount of money flowing into cash ISAs slowed to a crawl and even started to fall*
*Source: Bank of England
What is the Personal Savings Allowance
The Personal Savings Allowance (PSA) means that for basic rate taxpayers, the first £1,000 of savings interest earned each year is tax free. For higher rate taxpayers it’s £500, while additional rate (45%) taxpayers do not receive a PSA at all.
When introduced, it was estimated that 95% of cash savers would no longer pay any tax on the interest earned on their savings accounts and this brought about a radical change to how savings interest is taxed. Banks and building societies stopped automatically deducting 20% tax from interest earned and now all interest is paid gross. This means that if your total interest (excluding interest from cash ISAs) is less than your PSA there is nothing more you need to do.
If you receive interest in excess of the applicable PSA limit though, then the onus is on you to ensure the correct tax owed is paid. The tax will be collected automatically through the PAYE system, so it’s important to check your tax code document to make sure it’s what you expected, or the tax can be paid through self-assessment, if you complete a tax return.
Why are ISAs nicer again?
With interest rates rising, the PSA is being breached far more quickly and therefore more people will find themselves paying tax – or more tax than they were – on their savings interest.
In April 2016, the best easy access account on the market was paying 1.45% – so a deposit of £68,966 would have been needed to breach the PSA (assuming no other savings accounts were held), and half that for higher rate taxpayers. But as interest rates plummeted after we went into lockdown, with rates as low as 0.45%, a whopping £222,222 would have been needed to produce £1,000 in interest. Today, the best easy access accounts are paying over 3%, so savings of as little as £33,000 could breach the PSA – that’s a dramatic change.
Those who opened a 1-year bond a year ago could have deposited £66,667 before the PSA was breached, as the best rate was around 1.50%, but today, with rates of over 4% available, just £25,000 will see savers breaching the PSA (and again, half that for higher rate taxpayers) and therefore paying tax on any excess.
Mind the gap!
With savings interest rates falling to a historic low, exacerbating the lack of requirement for the cash ISA, the rates on offer dwindled even more than that of the non-ISA equivalent accounts, creating a huge gap between the two. So much so that it was not unheard of for the net (after the deduction of tax) return on a non ISA account to be even more than the tax-free interest of the equivalent cash ISA.
The good news is that as a result of the clear need for cash ISAs once again, the rates have also improved – and in many cases cash ISA rates have improved faster than non ISA accounts, reducing the gap considerably. This means that you should be able to earn more tax free interest on an ISA, than the net interest rate of the equivalent non ISA account.
What about old ISAs?
With interest rates having risen rapidly, it’s not just looking out for the best rates for your new cash ISAs that is important. You should also review any old cash ISAs that you hold and consider switching if you can earn more.
Unlike fixed rate bonds, fixed rate ISAs allow access before maturity, although often on the closure or transfer of the full amount, and there will usually be a pretty hefty penalty that will apply. However, depending on the interest rate you are earning and the rate you could switch to, it may still be cost effective to pay the penalty in order to enjoy far higher rates that are available today. But it’s important to do your math’s properly.
Easy access ISAs clearly don’t produce the same dilemma – so if you could earn more elsewhere, you can switch. But it’s important to realise, that there are strict rules when it comes to transferring a cash ISA.
How do you transfer an ISA?
Quite simply, if you want to switch, you must not close your existing ISA, as that will likely mean losing the tax-free benefit.
Instead, you need to approach the new provider you wish to move to and complete the cash ISA application and transfer forms. They will then contact your existing provider and arrange the transfer for you.
So what do you have to lose – except less interest? With the ISA season in full swing, which is traditionally when savings providers offer their best rates, take the time to review your savings portfolio and see how a cash ISA could increase the pounds in your nest egg.
To find out more about our ISA accounts for individuals, transferring an existing ISA from another provider, or using your ISA allowance for the year, please visit our website’s dedicated ISA Savings Accounts section.
Although this email and article may contain helpful information and tips, these are not personal advice. You may wish to seek advice from a financial advisor if you are unsure what’s best for your own personal circumstances.