But, even if you’ve let ISAs pass you by until now, the good news is it’s never too late to start. For the uninitiated, here’s a look at how ISAs work, and why you shouldn’t so much as look at an easy access account until you’ve first invested your full ISA allowance first.
What’s an ISA?
An ISA (Individual Savings Account) comes with special tax privileges. If you invest in a cash ISA you won’t pay income tax on the interest you earn and if you invest in a stocks and shares ISA, you won’t pay capital gains tax on your returns either.
ISAs were first introduced in April 1999, and were designed by the government to encourage us to save over the long-term.
Every UK resident who is 16 or over has an annual ISA allowance, which dictates how much money you can shelter from tax. In the current tax year it’s £11,280, of which up to half (£5,640) can be held in cash and the other half in a stocks and shares ISA. Alternatively, you can invest the whole £11,280 in stocks and shares.
As of April 6 this year, this allowance will go up to £11,520 – but the same rules will apply on splitting it between a cash ISA and a stocks and shares ISA. This means up to £5,760 can be held in cash.
This two minute video does a quick run-down of everything you need to know
How’s that different to an easy access savings account?
When you put your money in a standard savings account like an easy access savings account, your returns are taxed.
Let’s say you invested the same amount as your ISA allowance (£11,280) in an easy access account – here’s how it would break down:
If you’re a standard rate taxpayer you’ll pay 20% tax on the interest you earn. If you’re a 40% or 50% taxpayer, you’ll have to declare any interest earned from savings on your tax return and pay any additional tax due.
If you’re a basic rate taxpayer and put your £11,280 in a standard savings account with an annual equivalent rate (AER) of 1.55%, you’d earn £175 in interest over 12 months, but 20% of that would be taken in tax, leaving you with £140.
If you’d invested the same amount in a cash ISA with the same rate, you’d get the full £175, because ISA returns are not taxed.
Look at it this way – an easy access account paying 1.55% actually translates to 1.24% for a basic rate taxpayer, once you factor in how much will be taken in tax.
A cash ISA with a rate of 1.55%, however, is exactly that – aside from any temporary bonuses (usually lasting for 12 months), which also apply to some standard savings accounts anyway.
What’s more, ISA rates tend to be more attractive than easy access rates to begin with.
For example, the recently-launched Major ISA 2-Year Fixed Rate from Santander is paying an already market leading 2.80%, plus an additional 0.10% bonus if golfer Rory Mcllroy wins another major during the two years of the ISA deal.
If you have a 123 Current Account or 123 Cashback Credit Card with Santander you’ll benefit from an even better rate at 3.00%, plus the 0.10% bonus if Rory wins. So it’s possible to earn more than 3.00% on your ISA. The account also accepts transfers in from other ISA providers.
Halifax's two-year fixed rate ISA is next best with its fixed rate of 2.50% for two years. A quirk here is that, if you have £5,000 in this or any Halifax savings account for the whole of April, you'll be entered into a ‘Super Prize Draw’.
The draw will offer three top prizes of £250,000 and ten prizes of £5,000 in May. Each month, Halifax will also give away 100 prizes of £1,000 and 1,000 prizes of £100.
In terms of easy access ISAs, Santander has also introduced a new Direct ISA Saver which offers a joint market-leading rate of 2.50% for the first 12 months. After that time, the account reverts to an ISA Saver account, currently paying up to 2.00% tax-free with no bonus. The Direct ISA Saver requires a minimum investment of £2,500 and it does accept transfers in.
The Cheshire Building Society is paying the same variable rate of 2.50% on its ISA Saver (issue 1) which requires a lower minimum deposit of £1,000. The rate includes a 2.00% bonus payable until July 2014, so you’d need to make a note in your diary to switch accounts then.
The Barclays Bank Instant Cash ISA Issue 1 pays 2.30% (including a 0.80% bonus for 12 months), though on minimum balances of £30,000.
By comparison, the top-paying account over on our easy access accounts channel, the Halifax Online saver, pays an AER of 1.55% for balances of more than £1 and under £20,000.
Even the NatWest e-ISA, which has no rate-inflating bonus, beats the best easy access accounts on the market, with tiered rates starting at 1.75% on balances below £30,000. And you only need £1 to open that one.
So if you’re going to stash some cash away in a savings account, using your full ISA allowance first is a bit of a no-brainer. While returns tend to be higher on fixed rate ISAs, there are easy access ISA deals available too, which – just like an easy access savings account – mean you can get your hands on your money immediately. Bear in mind though, you only get one chance to use your allowance each year, so if you withdraw any, you won’t be able to pay it back in and claim the tax-free benefits.
Following our findings that the average saver would be £4,383 richer by opting for ISAs over easy access accounts, our head of banking, Kevin Mountford, said:
“ISAs should be a number one consideration for UK taxpayers who want to make the most of the tax-free benefits on offer. If you have savings and pay tax and don’t use your full allowance, you are throwing money at the taxman, which is not something any of us like to do.”
MoneySupermarket research found that nearly four-in-10 (39%) of people plan to save (or have saved) in a cash ISA this year, but only 28% of cash ISA savers plan to use their full allowance. It’s not too late to do something about this though – you have until April 5 to use your 2012/2013 allowance or lose it for good.
If you want to learn more about ISAs, visit our Great Big ISA Event page here.