Figuring out the best place to put your savings — whether it’s a typical savings account or a tax-free Isa — isn’t always an easy decision. The ridiculously low interest rates offered by savings accounts of all kinds over the past few years have hurt the appeal of Isas, as most ordinary savings accounts have allowed savers to earn some level of income. tax-free interest before reaching the Personal Savings Allowance threshold.
However, with the increase in rates that we have seen in recent weeks, the situation has changed somewhat. So what should savers consider when deciding whether to put their money in a traditional savings account or an Isa?
Why choose a traditional savings account?
Let’s start with the regular savings accounts you’ll find at major banks and the like.
These have particularly benefited from the combination of low interest rates and the personal savings allowance. The allowance defines how much you can earn in interest each year on your savings (before the taxman takes a cut) and is based on your income tax bracket.
Basic rate taxpayers receive a personal savings allowance of £1,000 a year. This drops to £500 for higher rate taxpayers. Extra-rate taxpayers are not eligible for any personal savings allowance, meaning every penny they earn in interest is taxable.
Given the low interest rates paid by savings accounts of all kinds in recent years, many savers haven’t earned enough interest to worry the taxman. In addition, the rates of the best savings accounts tend to be significantly higher than those paid by the tax-exempt Isa.
The first regular easy access account today pays a rate of 2.81%, significantly more than the 2.25% paid by the first easy access account Isa, for example. If you want to maximize returns, but those savings don’t earn enough interest to exceed your personal savings allowance, a traditional savings account may be the answer.
Finally, traditional savings accounts generally don’t have a cap on how much you can save in them. You are generally free to put as much as you want in the account, but keep in mind that the Financial Services Compensation Scheme only protects the first £85,000 saved at each financial institution in the event of bankruptcy .
The Case Against Traditional Savings Accounts
Once you start building up a bigger pot of savings, particularly if you’re a higher rate taxpayer, you’re much more likely to have to hand over some of the returns to HMRC.
AJ Bell recently calculated that higher rate taxpayers will start paying income tax on their interest once they have £21,250 in an easy access account – based on this account paying £2.35 %. Basic rate taxpayers, on the other hand, receive up to £42,500 before their savings are subject to tax.
It becomes even more pronounced if you choose to freeze your money for a longer period, thereby qualifying for a higher interest rate. For example, higher rate taxpayers who took out a one-year fixed rate account paying 4.11% would only need £12,175 in the account before they had to start paying tax on returns.
If interest rates on savings accounts continue to rise, more savers with traditional savings accounts will find their returns taxed.
Why choose an Isa?
The Isa allow savers to fully benefit from their savings efforts, completely tax-free. As a result, if you have a large savings pot, an Isa is required to appeal, although there is an annual Isa allowance – currently set at £20,000 for the 2022/23 financial year. Another positive is the variety of Isa type available.
- If you’re a saver who wants low-risk certainty, you can put your money in a Cash Isa, which works just like a traditional savings account, except returns are guaranteed tax-free.
- If you are happy to accept a little more risk, in exchange for the possibility of higher returns, then you can opt for a Stocks and Shares Isa. The types of investments that can be held in a Stocks and Shares Isa vary by provider, but it allows savers to enjoy every penny of the returns generated by individual stocks, funds, bonds and the like in their Isa.
- Alternatively, there is the Lifetime Isa. This is aimed at two distinct types of savers: those who wish to constitute a down payment to be used when buying a house or those who wish to save for their retirement. The money you save in a Lifetime Isa is eligible for a 25% government bonus each year, with a bonus capped at £1,000. You must be under 40 to open a Lifetime Isa.
- Another form of Isa investment available is Innovative Finance Isa, which can be used to invest in alternative assets like peer-to-peer lending.
- You can even use Isa to save money for your children in the form of an Isa Junior.
In addition to the range of different Isa types, another benefit is the fact that your annual allowance adds up each year. If you make the most of your £20,000 allowance each year, you can quickly build up a significant pot of savings, with every penny of interest kept by you.
The case against Isas
Any unused Isa allowance cannot be carried over to subsequent years. So if you save less than £20,000 in a tax year, that unused allowance will be gone forever. It could be frustrating if you suddenly come across a windfall – for example, a big bonus or an inheritance.
Also, you are only allowed to open one Isa of each type in a single tax year. Although you can spread your annual allocation over different types of Isas – save some money in a Cash Isa and a little in a Stocks and Shares Isa, for example – you cannot open two Isas of the same type this year – the.
Also, while Isas returns are tax-free, that doesn’t necessarily mean you’ll be better off using them. If you opt for an investment Isa (the Stocks and Shares Isa or the Innovative Finance Isa), there is a risk that the assets in which you invest will lose value. As a result, you may end up with less than you started with.
Even if you stick with the security offered by a Cash Isa, you’ll have to accept lower interest rates than you might get from a regular savings account.
Transferring money between Isas can also be tricky. Not all Isas accept incoming transfers. This means that you cannot transfer money already held in an Isa to it. It can mean limited choice when it comes to finding a new home for your savings. Additionally, money must be transferred directly from one Isa to another, in order to maintain its tax-free status.
Making the Most of Traditional Savings Accounts and Isas
Nothing prevents savers from using both Iass savings accounts and regular savings accounts. In fact, for some savers, it will make sense.
For example, if you have used all of your annual Isa allowance of £20,000, this does not have to be the limit on your savings. Once you reach this threshold, you can continue saving money in a traditional savings account.
It can also be a good idea to divide the money you save ‒ depending on whether you need access to it for the short or long term. Keeping a reserve of emergency money in an easy-to-access standard account can be useful for taking advantage of higher interest rates, while saving all the money you won’t need for more than a year. in an Isa.