Is a cash Isa now a good investment? Rates rise from rock bottom  

Cash Isas have had a terrible year, with rock-bottom rates and savers taking out billions of pounds. 

Both savers and providers are disinterested in these accounts, which were once the darling of the industry.

Now, however, the fates appear to be lining up to stop their dwindling appeal. Rates are edging up while tax rises are looming.

The big appeal of Isas is that your gains are tax-free — and cash Isas have always been the most popular type. In the 12 months to April 2020, 9.7 million cash Isa accounts were opened, with £48.7 billion flowing in. 

That compares with 2.7 million share Isas which attracted half the amount, at £24 billion.

The total amount in cash Isas stands at a huge £290.7 billion. But in the past 12 months, they have paid the lowest rates since their launch nearly 23 years ago, in April 1999. 

The average rate for new savers taking out a new account was just 0.51 per cent. That’s down on the 0.69 per cent in the previous year and half the 1.08 per cent of five years ago.

If you opened a new easy-access account last year, you’d have got 0.28 per cent on average, and even if you agreed to tie up your money for a year, you’d see only 0.68 per cent.

And the average paid to those already in fixed-rate and easy-access accounts is even lower, at 0.3 per cent.

What went wrong?

Last year, savers took an unprecedented £4.5 billion out of cash Isas as the cost-of-living squeeze began to bite and they became increasingly disappointed by record low rates.

They found they could earn higher rates in ordinary taxable accounts and still not pay any tax, thanks to their personal savings allowance.

From April 2016, the Government made the first £1,000 of savings interest earned in a year in an ordinary account by basic-rate taxpayers tax-free. The limit for higher-rate taxpayers is £500.

The change removed at a stroke the tax benefits of cash Isas for most savers. With interest rates low, savers could hold large sums in taxable accounts before hitting the threshold. 

And with rates on ordinary accounts usually higher than on Isas, they voted with their feet.

The top easy-access account pays 0.9 per cent (Atom Bank), while the Isa equivalent pays 0.66 per cent (Shawbrook Bank).

Similarly, on a one-year fixed-rate bond you can earn 1.6 per cent with Shawbrook Bank, United Trust of Investec Bank against only 1.3 per cent in an Isa with Leeds Building Society.

Basic-rate taxpayers can hold £110,000 in a taxable easy-access account at 0.9 per cent and still earn just £990 in interest a year. For higher-rate taxpayers, the figure is £55,000, with £495 interest.

With the top one-year fixed rate bond at 1.6 per cent, basic-rate payers pay no tax on £62,500 savings.

Rachel Springall, finance expert at Moneyfacts, says: ‘The Isa market has been devastated by low interest rates and the introduction of the personal savings allowance.

‘Despite this, most consumers put their money into cash Isas, even though a stocks and shares Isa may be more lucrative. Then there is the dramatic rise to £20,000 in the amount the taxman lets you put into an Isa each tax year. 

‘This is more than most savers can afford, so there is now no urgency to use the allowance before the tax year ends on April 5.’

The average amount put into a cash Isa in the April 2019 to 2020 tax year was just a quarter of the allowance, at £5,024. 

The total amount in cash Isas stands at a huge £290.7bn. But in the past 12 months, they have paid the lowest rates since their launch nearly 23 years ago, in April 1999

The annual allowance rose to £20,000 in April 2017 from a starting point of £3,000 at their 1999 launch. It rose gradually for years to reach £5,760, before the first big jump to £15,000 in 2014.

When the limit was lower and tax higher, savers rushed to shield as much money as possible from the taxman. Now it doesn’t matter to most savers if they don’t use their allowance in one tax year as they get a new one at the start of the next.

The ISA return

Frozen tax allowances and rising interest rates could bring Isas in from the cold.

The Bank of England had already raised its base rate from 0.1 per cent to 0.5 per cent before last week’s hike to 0.75 per cent and has signalled it plans to increase them to 1.25 per cent before the end of the year.

Cash Isa rates, particularly with smaller banks and building societies, will rise, too. This has already begun, with the top one-year fixed rate at last breaching the 1.2 per cent barrier.

Higher rates mean you will hit your personal savings allowance far more quickly in ordinary accounts. And you could end up paying a higher tax rate if you get a pay rise.

Millions face a bombshell from a freeze on tax thresholds. In last year’s Budget, Chancellor Rishi Sunak froze the personal income tax allowance and thresholds until March 2026. 

Usually they are upgraded yearly, so after-tax pay is not eroded by inflation. That no longer happens.

Currently, basic-rate tax is charged on any income over £12,570 a year, while the higher rate kicks in at £50,271 — and that is where the levels will stay for the next four years.

Cash Isa rates, particularly with smaller banks have already begun to rise, with the top one-year fixed rate at last breaching the 1.2% barrier

This means some four million Britons will be dragged into the 40 per cent higher-rate band over that time, the Centre for Economics and Business Research estimates. 

This would instantly halve your personal savings allowance from £1,000 to £500. Anna Bowes, of Savings Champion, says: ‘If you have £20,000 or less saved, go for the best rate whether it is an Isa or an ordinary account. 

‘You won’t pay tax on the interest, thanks to your personal savings allowance. You can always transfer it to an Isa later using your annual allowance.

‘But if you have a lot more cash, you might want to use this year’s Isa allowance so you won’t pay tax in the future when rates rise.’

Laura Suter, head of personal finance at AJ Bell, says: ‘If cash Isa rates rise, taxpayers will hit their personal savings allowance more quickly. They also need to consider how long it will take them to transfer their non-Isa savings into an Isa.

‘It could take more than a year, so they may want to start now as a precaution against rising rates or a salary rise pushing them into a higher tax bracket.’ 

You can transfer your cash Isa into a shares Isa at any time, so while the tax-free status may not look that valuable on cash savings, you keep open the option of investing in the stock market in later years, and the tax benefits then become valuable.

Pain of inflation

The big problem facing cash savers is inflation. The cost of living is rising by 5.5 per cent a year — its highest level for 30 years, and is predicted to go as high as 8 per cent in April.

As the interest you earn is much lower, the value of your savings and what you can buy with them will fall.

But workers need to hold up to six months’ salary in cash savings to tide them over in case they lose their job. They also need rainy-day savings for unexpected expenses.

Pensioners need cash to boost their pension to ensure that they are not forced to sell shares when markets are in the doldrums.

Some six million people aged 65 and over have Isas, of whom more than three million hold only cash with an average pot of £52,000.

Sarah Coles, a finance analyst with Hargreaves Lansdown, says: ‘Retired people should have one to three years’ worth of essential expenses in cash, depending on their pension income and their attitude to risk.’

Get the best rate

With inflation soaring, savers need to get every penny of interest. Ignore big High Street banks, which pay as little as 0.01 per cent interest — that’s 10p on each £1,000 – on cash Isas.

Smaller banks and building societies pay the best rates. Most top rates of 0.7 per cent plus on easy-access accounts are reserved for online accounts.

If you want a branch or postal account, try your local building society. Swansea and Melton Mowbray, for example, pay 0.8 per cent.

If you have a cash Isa with a lousy rate, you can transfer to a better deal. Most providers accept Isa transfers. 

Once you have found a new home for your Isa, ask the new provider to arrange the transfer. Don’t do it yourself or the tax-free status on the money could be lost.