Why Isas are still the best place for cash

George Osborne's new tax-free allowance on cash deposits is good news, says Merryn Somerset Webb. But don't neglect your Isa.

George Osborne wants to create a savings culture in the UK. That's a good thing, given that we haven't got much of one at the moment.

So you'd think that we would welcome the chancellor's announcement that, with effect from April 2016, basic-rate taxpayers will be able to earn up to £1,000 of interest per year on cash deposits tax-free (higher-rate taxpayers only get a £500 allowance). And we do but only half-heartedly.

Jonathan Eley, writing in the FT, is with us on this. The tax-free allowance is "a good idea in theory", says Eley, since "taxing savings interest sends a very negative message and erodes already threadbare returns". But it isn't all good. Why? First, the policy doesn't really benefit those that Osborne claims it is aimed at.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

To earn £1,000 of interest at current interest rates you would need to have around £60,000 on deposit. Not very many "hard-working families" have that kind of money sitting around. So the biggest beneficiaries will be not those families, but those "who are asset rich with sub-£40,000 incomes". And "you can probably guess who they are". The other slight problem with the policy is that it makes cash individual savings accounts (Isas) look increasingly pointless.

If your interest is tax-free anyway, there is little reason to stick it in an Isa particularly as you can usually get a better rate of interest outside an Isa. That's a shame, since the government should be encouraging people to be saving inside Isas.

Richard Evans, writing in The Sunday Telegraph, explains why. Let's say you decide to give up on Isas and instead save £10,000 a year in deposits that pay 2% a year. It takes you five years to build up enough savings for the interest to be taxed.

At that point you go back to using Isas. But let's then say that rates begin to normalise and that the interest rate on those savings goes up to 4% a year.You are now liable for tax on the extra interest which you wouldn't have been in an Isa.

You might have received a slightly higher rate of interest tax-free in the short term by holding your money outside an Isa. But in the long term, you've given up valuable tax-wrapper rights by allowing each year's Isa allowance to go by unused. That's particularly the case if you might want to transfer the money you have in cash to a stocks and shares Isa at any point.

If the cash is in a cash Isa, you can shift it all over in one go, whereas if you keep the cash outside an Isa, you'll only be able to pay in a certain amount each year. Once inside an Isa, all the capital gains and the dividend income will be tax-free. That's a perk that, over the long term, will be worth many multiples of the extra interest gained on the money outside an Isa.

Merryn Somerset Webb

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast -  but still writes for Moneyweek monthly. 

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.