If you’re not quite sure what makes a cash ISA different from a savings account, you’re not alone. It’s a question that is commonly asked, but as a saver, it’s important to know what stands the two types of accounts apart. In short, an ISA (individual savings account) is a wrapper that you can put money into, allowing you to build up savings, tax-free (ie the tax man doesn’t take a slice of the interest you earn). While there are different types of ISAs, in this article we will just focus on cash ISAs. The current ISA limit is £20,000 per year. With a savings account, interest is only free up to a point. Above this, any interest you earn is subject to income tax. But any gains within an ISA is always tax-free.
What is the savings allowance?
When getting to grips with the difference between a savings account and a cash ISA, the key thing you need to get your head around is what is known as the ‘personal savings allowance.’ Introduced in 2016, this enables basic-rate taxpayers to receive £1,000 of interest each year tax-free.
For higher-rate taxpayers, this falls to £500, and if you’re a 45% taxpayer, this drops away altogether.
When interest rates are low, you would need to save a significant amount to breach the £1,000 savings allowance limit on a standard savings account. Until recently, rates had been at rock-bottom, so the personal savings allowance had somewhat undermined the need for cash ISAs.
However, now that rates are higher, the situation is different. Higher interest rates have led to a dramatic reassessment of the value of cash ISAs. For the first time in more than a decade, tax on cash interest rates has become something that savers need to think about. If not, there’s a risk you could end up having to hand over money to the taxman.
Given that interest rates are now expected to remain higher for longer, it’s become far more important to use tax shelters, protect yourself from tax, and keep more of your interest in your own hands. So, to summarise the difference between a savings account and an ISA, with a standard savings account, interest is tax-free up to a threshold. Then, once you earn more than £1,000 as a basic-rate taxpayer (or £500 as a higher-rate taxpayer), you are taxed on everything above that. By contrast, with a cash ISA, all interest is tax-free. For as long as the money is in the ISA.
Cash ISA v savings account
Why choose a savings account
If you’re slotting away more modest amounts of money away and are unlikely to breach the £1,000 savings allowance, the better option for you might be a standard savings account – especially as cash ISAs often pay a little less. But before opting for a standard savings account over a cash ISA, make sure you compare rates. You want to ensure your money is working as hard for you.
Also be sure to go in with your eyes open, as you need to watch out for any restrictions on withdrawals and be alert to introductory rates which lure you in, but then drop away after a period. Lots of people get caught like this and their savings languish in poorly paying accounts for many years. Keep track of your money and move it elsewhere as soon as the rate changes or expires.
Why choose a cash ISA
If you are looking to build a decent pot of savings over a slightly longer period, then you may be better focusing your attention on a cash ISA. You can put away £20,000 a year tax-free. And if you were to do that every year, you could ultimately amass a pretty significant nest egg. As all the interest will be tax-free, you can keep it firmly away from the taxman’s grasp. If, by contrast, you saved bigger sums in a standard savings account, you would soon earn more than £1,000 in interest, meaning that the rest would be subject to tax and the taxman will take a slice.
As mentioned above, sheltering your savings from the taxman has become especially pertinent right now with interest rates having risen, and amid expectations they will stay high. Cash ISAs are an obvious port of call for those looking to protect their savings.
Are there any downsides to opting for a cash ISA?
While there are lots of upsides to squirrelling money into a cash ISA, you need to be aware that you will usually have to accept a slightly lower rate of interest than you might get on a standard savings account.
That said, right now, the implications of not sheltering your interest from tax are likely to outweigh the small hit you take on the headline rate.
So what’s the key difference between a cash ISA and a savings account?
If you slot your money away into a cash ISA, your interest will be tax-free forever. Do the same in a standard savings account, and there will be a limit to the amount you can earn tax-free.
What about stocks-and-shares ISAs?
Another thing you need to remember with a cash ISA is that even though the value will never fall, over time, it may be vulnerable to the effects of inflation. With this in mind, for longer-term saving, it’s likely to make more sense to opt for a stocks-and-shares ISA. Even though you are taking on a degree of risk with investing, a stocks-and-shares ISA does offer the potential for actively growing your money over time to beat inflation – while saving you tax at the same time.
Photo by Natee Meepian on Canva
