Update: 1 July 2014: ISAs have today transformed into NISAs (New ISAs), meaning everyone can now put £15,000 into cash or shares savings without paying tax on it. But despite this bigger allowance, the principles of this blog still apply.
The new cash ISA year started yesterday. Our best pick pays 2.75%, but some bank accounts pay up to 5% interest (before tax) as loss leaders in order to pull money in. So while savers’ money is generally nicer in an ISA in the long run. In the short term, the bank accounts win. Yet there is a way to get the best of both worlds…
As many have asked me which wins, cash ISAs or bank accounts? I wanted to bash out a logical path through this conundrum. To establish which is best, we first need to look at both contenders for your savings cash (or jump to ‘The best of both worlds’).
Contender 1. The top bank accounts pay up to 5% BEFORE tax
Bank accounts were once the worst place to stash cash, paying diddly-squat. Yet with savings rates at all-time lows they’ve seen an opportunity to use high rates to flog current accounts. So now, provided you’re willing to switch account (or you may already have one) they’re top interest payers.
Which one to choose depends on how much cash you’ve got (see the table below). You should focus on covering more of your money at a decent rate, rather than going for the one with the highest rate. For example, if you’ve got £12,000, Santander’s 3% beats Lloyds’ 4%.
| THE TOP CURRENT ACCOUNTS WITH IN-CREDIT INTEREST
For comparison, the top easy-access savings deal pays just 1.5%.
|Current account||In-credit interest (AER)||After basic tax||After higher tax||Max interest each year (1)||Intro bonus|
|Santander 123 (2)||3% on whole amount if you’ve £3,000-£20,000. Plus up to 3% bills cashback||3% becomes 2.4%||3% becomes 1.8%||£450 (after fee)||–|
|Club Lloyds||4% on whole amount if you’ve £4k-£5k (3)||4% becomes 3.2%||4% becomes 2.4%||£157||–|
|Nationwide FlexDirect||5% up to £2,500 for 12 months, 1% after||5% becomes 4%||5% becomes 3%||£98 (year 1)||–|
|TSB Plus||5% up to £2,000||5% becomes 4%||5% becomes 3%||£78||–|
|Halifax Reward||£5/month as long as you stay in credit||The £5 is after basic tax||£3 (you’ll need to state the interest on your tax return)||£60||£100|
|First Direct 1st Account||None||n/a||n/a||None||£100|
|(1) Estimated post basic tax interest, if you always held the max balance or more. (2) Has £2/mth fee, but for most, cashback more than covers it. It pays 1% savings interest on £1k-£2k, 2% on £2k-£3k and nothing on above £20,000. (3) 1% under £2,000, 2% on £2k-£4k.|
While the amounts here are limited, it is possible in all cases to open two of the same account (four with TSB), though in all cases one (two with TSB) must be joint accounts. But doing this is fiddly and you normally need to ensure you meet the minimum pay-in with each. Some accounts also require you to pay direct debits from each account.
Contender 2. The top pick cash ISAs pay 2.75% AFTER tax
A cash ISA is just a savings account where you don’t pay tax on the interest. From this tax year, which started yesterday, you can put in £5,940. However from July when the new NISA starts, you’ll be able to top this up to £15,000. From this point on I’ll assume you understand cash ISAs, if not please first read the full Top Cash ISAs guide.
Top easy-access – 1.6%. To compare like for like with the top bank accounts we need to look at the top easy access cash ISA (as all the bank accounts are by definition easy-access, meaning they don’t require any notice to take your cash out).
Here, the winner is Santander’s 1.6% AER variable Direct ISA (minimum £500), which lets you put new money in and transfer old ISAs to up the rate.
Yet most people can earn 2.75%. People often plump for easy-access out of nervousness that they will need the cash. Yet unless you definitely need it and need it soon, you can earn much more in a fixed ISA – as unlike fixed savings accounts – by law they have to allow you access to your cash. They can however levy interest penalties for early withdrawals.
My top pick is the Coventry BS 4-year 2.75% cash ISA (min £5,760, no transfers) which allows you to close the account and withdraw early for a relatively low penalty, just 120 days’ interest.
A number crunch shows if you withdraw after a year, you’d effectively have got 1.85%, beating the best easy-access deals. After two years it’s 2.3%, beating the best two-year fix, and after three years, 2.45% which beats the other 2.25% best buys.
So which wins? Bank accounts or cash ISAs?
On rate, even after tax the top bank accounts ALWAYS beat the best easy-access deal, and some beat the top fixed deal too.
So if you’re only planning on having cash in an account for a short time – go for the bank account. However that isn’t the end of it, as I touch on in my Santander 123 v cash ISAs blog published in the last tax year, two weeks ago. You need to factor in the long term ISA gain.
While the interest given by bank accounts is usually ‘variable’, which means it can change due to interest rate moves or simply at the provider’s whim, most will tend to keep their offered rate for a while although at some point it’s likely they’ll reduce it closer to normal savings rates.
So the gain of cash ISAs is longer term. Of course easy-access cash ISA rates are variable too, but putting money in an ISA now means it’s not just tax-free this year, it remains tax-free year after year. So even if your provider’s rate drops, you can do a cash ISA transfer to shift it to a different account and retain the boon of its tax-free status.
This means the benefit of stashing cash in an ISA each year is very important, especially for those with larger savings. In the long run when interest rates bounce back, you will then gain substantially from having as much of your savings as possible protected from tax.
So it is worth considering doing that even at the cost of giving up the short term interest rate boost from the loss leading high interest bank accounts.
The best of both worlds
There is a half way house solution for those who want to get the long term gain of filling up their ISA allowance to maximise tax free savings, and take advantage of the short term high rates offered by bank accounts – you can do both.
Step 1: Shove cash into the high interest bank account. Do this right now rather than open an ISA and don’t use your 2014/15 cash ISA allowance.
Step 2: A week before the ISA year ends, use the cash to open one. At the end of March next year – just move the cash out of the bank account and then open your ISA to fill the allowance.
This way you get to protect your cash from tax in the long term, but gain the higher, short-term interest now.