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 up to £5,640 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 20, 40 or 50 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 £5,640, although that amount tends to rise with inflation year-on-year as the government strives to encourage saving. Your money is secure in the ISA: you’re not going to lose it, though its value may be eroded by inflation.
Every new financial year you can add an extra £5,640 (or whatever the limit rises to). However, the allowance is set on a ‘use it or lose it’ basis, meaning if you don’t invest the full £5,640, you lose the unused allowance going into the next year.
Money can be transferred from a cash ISA to a stocks and shares ISA at any time, but not the other way. So if you don't feel comfortable investing in stocks and shares right now, but think you might want to in future, a cash ISA can be a good way of ensuring you use some of this year's valuable ISA allowance.
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 switch between ISA providers to get the best deal.
Luckily, it is relatively simple 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, often 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 instant access account at the time of writing is a 3.3 per cent offering from Santander, though that interest is boosted by a 2.8 per cent ‘bonus’ rate and will decrease to 0.5 per cent after 12 months. The best non-bonus rate is currently 3 per cent from Marks and Spencer.
All the best cash ISA rates are available from Moneyfacts.
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