How to choose a cash Isa

Published:
06 March 2009
Topic:
News,Money,ISA,Savings

With interest rates at record lows it's more important than ever to maximise the returns on your savings. Cash Isas are therefore well worth taking advantage of because interest is paid tax-free. Yet research from Birmingham Midshires suggests that two thirds of savers will fail to make use of their Isa allowance.

Confusion and apathy are among the main reasons why so many people stand to lose this valuable tax break, so we explain what Isas are, why they are worth taking advantage of and what you should look for when comparing cash Isa accounts. You can also learn more by watching our video blog 'Cash Isas explained'.

What are Isas and how do they work?

Every adult has a £7,200 individual savings account (Isa) allowance which can be invested each tax year (the tax year runs from 6 April to 5 April). The entire amount can be invested in a stocks and shares Isa, or the allowance can be split and up to £3,600 put into a cash Isa.

Returns on Isas are tax-free making them a highly valuable tax-break. This means that as far as cash Isas are concerned higher rate taxpayers effectively get a 40% boost to their interest rate, while those in the basic tax band receive a 20% uplift.

Calculations from moneysupermarket.com show that savers who have used their full cash Isa allowance since the savings scheme was introduced in April 1999 would be £2,700 better off than basic rate tax payers who have saved in a standard savings account. Those in the 40% band would have netted themselves an extra £4,800 in interest.

So, if you're a taxpayer looking for a new home for your savings and have yet to use your Isa allowance this year, the first £3,600 should go in a cash Isa - it's a no brainer.

Are all cash Isas the same?

There are different types of cash Isa accounts just as there are different types of savings accounts - you can choose from easy access, regular and fixed savers.

Easy access accounts - these allow you to pay money in and take it out at any time. Rates are usually variable so they tend to fall if the Bank of England cuts interest rates.

Regular saver accounts - this type of account pays a fixed rate of interest for a set term - often 12 months - but you usually have to pay money in every month during that time. The amount you can deposit each month is capped - you will not be able to pay in more than £300 a month as this would take you over your annual £3,600 Isa allowance.

Withdrawals may not be permitted until the account matures. If withdrawals are allowed there is often a penalty such as a reduced interest rate.

Because you must deposit money every month, this type of account is not suitable for those looking to invest their entire Isa allowance for the 2008-09 tax-year now. A regular saver could be worth considering though if you want to start investing your 2009-2010 Isa allowance gradually when the new tax year begins in April.

Fixed rate accounts - Fixed rate Isas tend to pay a higher rate of interest than those available on variable accounts. However, you cannot normally access the money during the fixed term so only consider this type of product if you have savings you can afford to lock away for a year or two.

Another common feature of fixed rate deals is that they only permit a single deposit so are only suitable if you have a lump sum to invest.

Key thing to bear in mind: Before deciding where to invest your Isa allowance, you therefore need to think about what type of account is most suitable.

With interest paid free of tax, you should aim to keep your Isa savings invested for as long as possible - as soon as the money is taken out of an Isa account you lose the tax-free status. If you need to dip into your savings you should therefore use money in non-Isa accounts first.

Can I move money invested in previous tax years?

If you have money from previous tax years sitting in accounts that are no longer paying a decent rate of interest, you can move it to a more competitive deal without losing the tax-break.

However, you need to be careful. Whatever you do, don't close your existing account or accounts first as it will be classed as a withdrawal and you will lose the tax-free status on the money. Instead, tell your new Isa provider that you have money you want to move into the new account and it will arrange the transfer.

Not all Isas accept transfers in so you will need to check this when comparing deals.

Are there any catches to watch out for?

Transfer restrictions - as mentioned above, not all accounts accept money invested in previous tax-years.

You should also look to see if your existing provider will charge you a penalty for transferring money out of an Isa. This is less common than accounts not accepting transfers in, but is something to be aware of. 

Restricted eligibility - We're seeing an increasing number of providers offering Isa deals that are only available to existing customers. Royal Bank of Scotland (RBS) and Natwest for example have some of the leading cash Isa deals, but you can only open an account if you have a current or savings account with them.

Double investment - Abbey and Alliance & Leicester (A&L) are both offering Super Direct Isas paying a highly attractive rate of 5.5%. However, there is a major catch - in order to qualify for that rate (which is only applicable for the first 12 months) you must put an equal amount in one of the bank's stock market investment products.

Limited withdrawals - It's usual for fixed rate or regular saver Isas to restrict access, but even some 'easy access' accounts may impose withdrawal restrictions. You may only be permitted to make a certain number of penalty-free withdrawals a year, or receive a lower rate of interest if a withdrawal is made.

Bonuses - Watch out for accounts that carry a short term interest bonus, usually up to 12 months. Your rate may become uncompetitive at the end of this period, in which case you'll need to move it to a better paying deal.

How safe are your Isa savings?

The Financial Services Compensation Scheme protects the first £50,000 you have invested with a single institution. So if you're investing in a cash Isa for the first time, there's unlikely to be any issues if the banking institution were to collapse as your money would be guaranteed. However, if you have used your Isa allowance every year or have any other money in standard savings or current accounts, with that financial institution, you must be careful.

It is important to spread your money around between different providers if you have more than £50,000 in cash savings. For more tips on how to do this, read our article 'Who owns who?'.

Disclaimer: Please note that any rates or deals mentioned in this article were available at the time of writing.

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