Thinking of opening a Cash ISA? Here’s why they aren’t what they used to be

Young woman smiling putting a coin inside piggy bank as savings for investment

A Cash ISA is just a normal savings account, except for the fact that you don’t pay tax on any interest. With this in mind, surely it’s better to stash your savings in a Cash ISA, rather than a savings account, right?

Well, it’s not that simple these days, because Cash ISAs have lost some of their shine in recent years. Here’s why.

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What is an ISA?

ISA is short for individual savings account. It’s a type of product that’s been around for more than 20 years. There are four main types:

  • Stocks and Shares ISA – this type of ISA allows you to keep your investment income tax-free.
  • Innovative Finance ISA – a specialist ISA enabling you to invest in peer-to-peer lending.
  • Lifetime ISA – an ISA targeted at first-time buyers, or those keen to save for retirement. 
  • Cash ISA – an ISA in which you can save without paying tax on the interest you earn. 

Everyone gets an annual tax-free Personal Savings Allowance that applies across all ISA types.

In the 2021/22 tax year, the allowance is £20,000. It’s worth knowing that if you don’t use your allowance in a given year, you can’t roll it over into the next tax year. 

How does a Cash ISA compare with a normal savings account?

By now you’ll have recognised that a Cash ISA is essentially just a normal savings account. The only difference is that you don’t pay any tax on interest.

This may seem like a big benefit at face value. However, there are two main reasons why you may wish to consider opening a normal savings account over a Cash ISA. 

Reason 1: Savings accounts pay higher interest than Cash ISA accounts

We all know that savings rates are currently very low from a historical point of view. Right now, the highest interest rate available on an easy-access savings account is from Tandem Bank, which pays 0.65% AER variable interest. This is closely followed by accounts from Aldermore (0.6% AER variable interest) and Tesco Bank (0.59% AER variable interest).

Compare these easy-access accounts to the top cash ISA offerings and the highest interest rate available is 0.6% AER offered by Cynergy Bank. Paragon Bank, Leeds Building Society, and Coventry Building Society all offer accounts paying 0.55% AER variable interest.

The difference in interest rates becomes even more apparent when looking at fixed-term accounts. Currently, you can earn 1.5% AER variable interest in a one-year fixed savings account through Atom Bank. Yet the highest interest rate on a one-year fixed-term ISA is a pay 0.85% AER variable interest, via Coventry Building Society.

To compare more rates, see our lists of the top-rated fixed-term savings, and fixed-term Cash ISA accounts. [middle_pitch]

Reason 2: The Personal Savings Allowance means most don’t pay tax on savings anyway

It used to be the case that any interest you earned in a normal savings account was taxable. This is why Cash ISA products were more attractive back in the day, especially as Cash ISA interest rates were also more competitive!

Yet the tax-free status of Cash ISA accounts lost their attractiveness in 2016, following the introduction of the Personal Savings Allowance. That’s because the allowance allows most people to earn interest in a normal savings account without having to pay tax. Your personal allowance limit varies depending on how much you earn:

  • Basic-rate taxpayers are entitled to earn £1,000 a year in interest tax-free in a normal savings account.
  • Higher-rate taxpayers can earn up to £500 per year, before having to pay tax on interest through a normal savings account.
  • Additional-rate taxpayers don’t qualify for the allowance.

With the allowance in mind, if you’re a basic or higher-rate taxpayer, these generous tax-free limits mean that you’re unlikely to have to declare any tax on the interest you earn in a normal savings account.

For example, take the top easy-access savings account paying 0.65% AER variable interest. Assuming the interest rate doesn’t change during the tax year, basic-rate payers would have to save roughly £155,000 in this account before having to pay any tax on interest.

Meanwhile, higher-rate payers would have to have £77,000 stashed in the same account before interest becomes taxable.

How can I find the highest interest rate for my savings?

Whether you opt for a Cash ISA or a normal savings account, it’s worth searching for the highest possible interest rate. To help you choose an account, see our lists of the top-rated Cash ISA, and normal savings accounts.

Looking to invest instead? If you’d rather invest than save, then it’s worth remembering that you can use your ISA allowance in a Stocks and Shares ISA. If you’re new to investing, it’s a good idea to read our investing basics to understand the risks.

The post Thinking of opening a Cash ISA? Here’s why they aren’t what they used to be appeared first on The Motley Fool UK.

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