It seems that we do love a Cash ISA compared to the other options, as shown in the graph from the Office of National Statistics (ONS) below. But with interest rates at all-time lows, is cash the best place for our savings?
We’ll take a closer look at other types of ISA over the next few weeks, but for now, let’s get into some of the detail behind the relatively straight forward Cash Individual Savings Account (ISA).
How do they work?
Cash ISAs are really just bank or building society accounts, although you can also open them with National Savings & Investments. Basically, they are savings accounts with no tax deducted on any interest that you earn.
Some offer instant access with an interest rate that rises or falls when the Bank of England changes the base rate. Others offer a fixed rate over a set number of years, although you should expect a penalty if you make an early withdrawal from these.
So opening up a Cash ISA is pretty much like opening any other savings account, although you do need to be UK resident with a National Insurance number.
What are the benefits?
First off, any interest you earn is sheltered from tax. That’s nothing to get excited about right now, because interest rates are so low. You can only expect around 0.1% on easy access accounts at the moment. But if you imagine maximising your ISA contributions every year, it could become a real benefit when interest rates rise in the future.
I remember when I started work in the bank in the early 1990s, savings accounts paid up to 15%. Who knows where interest rates will go in the future, so there’s nothing wrong in maximising tax-free allowances in the hope that earnings might improve.
Having said that, since April 2016, we all have a personal savings allowance, which means most people will not pay tax on their savings interest anyway. For this tax year, basic rate taxpayers can earn £1,000 of interest before any tax is due. The allowance drops to £500 for higher rate taxpayers and if you’re an additional rate taxpayer, the allowance is withdrawn and you will be taxed on all interest earned outside of an ISA.
Think of it this way. If you’re a basic rate taxpayer earning 0.1% interest, you would need a cool million in cash savings – outside an ISA – before you started paying tax on the interest. So that makes Cash ISAs seem a little bit pointless for most folks at the moment.
But remember, if you don’t use your allowance now and interest rates rise in the future, you can’t backdate contributions. Use it or lose it.
Other than that, the beauty of Cash ISAs are they are straight forward, easy to understand and your savings are protected by the Financial Services Compensation Scheme up to £85,000 per bank.
You can check if your savings are protected here.
What are the drawbacks?
ISAs are designed to encourage us to save, so there can sometimes be restrictions on withdrawals, usually with fixed rate ISAs.
Some might consider the annual allowance of £20,000 to be a drawback, although it’s a generous enough allowance for most.
Other than that, the main drawback is the lack of long-term growth potential. Any bank or building society deposit will struggle to grow in line with inflation over the long term. The spending power of your money can gradually erode over time. For example, if you have £10,000 in a Cash ISA earning 0.1% interest, you will earn £10 after a year. But inflation at the current rate of 0.7% means that, after a year, your £10,000 will only buy £9,930 worth of goods and services. So you gain £10 and lose £70 in real terms. Imagine the compound effect of that over many years.
This is not of much concern if you’re planning to spend the money within a few years, or if your Cash ISA is acting as your ‘emergency fund’. But generally, this is not a good option for long term investment of more than 5 years.
What are the rules and restrictions?
For the 2020 / 2021 tax year, ending on 5th April, the annual ISA allowance is £20,000 per person. This includes contributions to all types of ISA.
ISAs cannot be held in joint names, you cannot open one on behalf on someone else and they cannot be held in trust.
You can only pay into one of each ISA type per tax year, so you can’t pay into 2 different cash ISAs in the same tax year.
You could, however, pay into both a cash ISA and a stocks & shares ISA. or even a Lifetime ISA or Innovative Finance ISA.
One other thing to be aware of is flexibility of withdrawals. It’s usually easy enough to make a withdrawal from a Cash ISA, but if you’ve made use of your full allowance for the year and you withdraw money, you might not be able to pay it back in again until the following tax year.
It depends on whether or not your ISA product is ‘flexible’ but you’ll be able to confirm that with your provider.
Cash ISAs are available to those aged 16+, so if you want one for kids, you’ll need to open up Junior ISA instead.
Are they worth it?
As noted earlier, there’s not a massive benefit at the moment because interest rates are so low and the majority of savers would be covered by the personal savings allowance anyway.
But don’t forget about the benefits of forward planning. The more you can get into ISAs now, the more tax could potentially be saved in the future, when interest rates rise again.
Generally, it’s good practice to make as much use as you can of tax-free allowances, so don’t be put off by temporarily low interest rates. But also consider the purpose of your savings – if you’re building wealth for the long term, it’s worth looking into stocks and shares ISAs.
If you do go ahead with a Cash ISA, it’s best to shop around on some comparison websites, such as money.co.uk or moneysupermarket.com. You can still find rates as “high” as 0.6% if you can tie the money away for 2 or 3 years.
Cash ISAs are straight forward, low risk and they can help build up a pot of cash that’s protected from the tax man. Don’t waste your ISA allowance – but do consider if Cash is the best option for you.
Cash ISAs might be the most popular, but they have a purpose – and it’s not to grow wealth over the long term.