Holding cash in an ISA is one tax avoidance scheme that the government positively encourages. What Investment‘s guide to cash ISAs explains how you can save thousands of pounds a year tax-free.
Cash ISAs are savings accounts held within a tax-free ISA wrapper, which keeps the interest earned on your money completely safe from the taxman. Normally you would pay tax on your interest at 10, 20, 40 or 45 per cent, depending on which rate of tax you pay on your income – so the money you save by using an ISA could be considerable.
The annual limit on the amount you can deposit into a cash ISA is currently £5,940, although after 1 July 2014 this will be increased to £15,000. If you have a stocks and shares ISA as well, the total you save across this and the cash ISA cannot exceed the annual limit of £11,880, or £15,000 after 1 July 2014.
Your money is secure in a cash ISA: you’re not going to lose it, though its value may be eroded if the interest you receive is less than the rate of inflation.
Even if the financial institution that provides the cash ISA goes bust – a highly unlikely scenario – you can recover up to £85,000 of your savings through the Financial Services Compensation Scheme (FSCS), as long as that provider is covered by the scheme.
Cash ISAs provided by all banks, building societies and major financial institutions are covered by the FSCS.
How your ISA allowance works
Every new tax year (beginning in April) you can add extra money to an existing cash ISA, within the limit set for that year, or open a new one. You can have as many cash ISAs as you like, but you can only open one per tax year.
Your ISA allowance is granted on a ‘use it or lose it’ basis, meaning if you don’t invest the full amount, you lose the unused allowance going into the next tax year. In other words, you can’t ‘roll over’ part of your allowance. Once you have invested money in a cash ISA, it counts as using up of your allowance, even if you withdraw it later.
Money can be transferred from a cash ISA to a stocks and shares ISA at any time, but until 1 July 2014, this is a one-way street: you can’t move from stocks and shares back to cash. However, after 1 July 2014, the government will allow you to move money either way, and this applies not just to ISAs opened this tax year but to any ISAs that you might have opened in previous years.
This flexibility means that if you don’t feel comfortable investing in stocks and shares now, but you might want to in future, you can put money into a cash ISA this year and transfer it to a stocks and shares ISA in a future tax year, without using up any of the future tax year’s allowance.
Cash ISA interest rates
The minimum investment required to open a cash ISA can vary from £1 to £2,500, depending on the provider and, while most accounts can be opened online, in branch, by post or by phone, some providers don’t offer all of these services. In fact, some of the best rates are available from online-only operators, because they can save money by not running branches or phone lines.
The best cash ISA rates tend to be a few per cent higher than the Bank of England rate, which is currently 0.5 per cent. Any rise or fall in the base rate is likely to lead to a corresponding change in the ISA interest rates on offer, although there may be a delay in providers changing their rates (especially when the base rate goes up!)
One important word of warning. Cash ISAs tend to offer attractive initial ‘bonus’ rates, often available for the first 12 months, before switching to a much lower rate from then on. This means you will need to keep switching between ISA providers to get the best deal.
Luckily, it is relatively simple and quick to transfer cash ISAs between providers, though you need to ask your provider to transfer your money across to ensure that you don’t lose your allowance. Before you open an ISA, make sure the provider won’t charge you an exit fee – most don’t but a few do.
Another important thing to consider is how easy it will be to access your money. The terms of cash ISAs vary in this respect:
Instant access ISAs
Many cash ISAs allow you to access your money instantly, any time you want. These are ideal for holding cash you may need in an emergency. Interest rates tend to be variable, or fixed for a ‘bonus period’ after which they will revert to a lower rate.
ISAs with a notice period
These require a certain period of notice (often 60 days) before you can withdraw money. If you need the money earlier, you will pay a penalty, usually in the form of a loss of interest. Interest rates tend to be variable after any bonus or introductory period.
Fixed-term (or fixed-rate) ISAs
These ‘lock away’ your money for anything between one and five years at a fixed interest rate. They often pay better rates of interest but they do not allow withdrawals during the fixed term; if you need money, you’ll pay a penalty or lose some of the interest you’ve earned.
The best cash ISA rates
The best instant access account at the time of writing is a 2.25 per cent offering from Harpenden Building Society. To get a higher interest rate, you’ll need to look at a fixed-term offering. For example, the First Save 7 Year Fixed Rate Bond (online only) will pay 3.5 per cent for seven years.
As a minimum, you are looking for an ISA that pays an interest rate higher than the UK’s rate of inflation (currently 1.7 per cent). Otherwise, your cash ISA is losing you money in real terms.
Note that when you sign up to a multi-year fixed-term ISA, the rate might look attractive now, but it might not seem so good in future. For example, in two years’ time the Bank of England base rate might have risen from 0.5 to 3 per cent and there might be several instant access ISAs on the market paying 4 or 5 per cent. In this situation, the seven-year ISA you signed up to paying 3 per cent won’t seem such a good deal.
All the best cash ISA rates are available from Moneyfacts.
Cash ISAs can contain other assets than just cash. For example, they can contain certain National Savings and Investments (NS&I) products as well as structured deposits.
Structured deposits protect 100 per cent of your original capital, but offer the chance to earn more interest than you would get from a cash ISA if the stock market performs well. If the stock market doesn’t perform well, you might earn no interest.
For example, the Investec FTSE 100 Target Income Deposit Plan 10 has a six-year term, and will pay annual interest of 4.85 per cent provided that the FTSE 100 share index has not fallen more than 10 per cent by each anniversary date.
Don’t confuse structured deposits with structured investments, which can lose you money.
More information about structured products is available in What Investment‘s free downloadable guide.
Guide originally published: 18/7/12. Updated: 3/4/14.
Related investment guides:
- Making cash work harder – fixed-rate bonds and money market funds
- Understand the basics of ISA investing
- Stocks and shares ISAs – a flexible ISA with higher risk for more experienced investors
- An investment guide to retail bonds
- An investment guide to bonds – UK government bonds, or gilts, are regarded as very safe investments
- ISAs versus SIPPs – two tax-efficient wrappers compared