Isas vs savings accounts: what’s the best home for your cash savings?

Determining the best place to put your savings – whether a typical savings account or a tax-free Isa – is not always an easy decision. The paltry interest rates on offer from savings accounts of all kinds over recent years have dented the appeal of Isas, as most regular savings accounts have allowed savers to earn some level of interest tax-free before hitting the personal savings allowance threshold. 

However, with the increased rates we’ve seen in recent weeks, the situation has changed somewhat. So what do savers need to consider when deciding whether to put their money into a traditional savings account or an Isa?

Why choose a traditional savings account?

Let’s start with the regular savings accounts that you’ll find on offer from high street banks and the like.

These have particularly benefited from the combination of low-interest rates and the personal savings allowance. The allowance sets out how much you can earn in interest each year from your savings (before the taxman takes a slice) and is based on your Income Tax band. 

Basic rate taxpayers get a personal savings allowance of £1,000 per year. This drops to £500 for higher-rate taxpayers. Additional rate taxpayers are not eligible for any personal savings allowance, meaning every penny they earn in interest is taxable.

Given the low-interest rates paid by savings accounts of all kinds in recent years, many savers have not earned enough in interest to trouble the taxman. What’s more, the rates on the best savings accounts tend to be noticeably higher than those paid by tax-free Isas. 

The leading regular easy access account today pays a rate of 2.81%, significantly more than the 2.25% paid by the top easy access Isa, for example. If you want to maximise returns, but aren’t earning enough in interest from those savings to exceed your personal savings allowance, then a traditional savings account may be the way to go.

Finally, traditional savings accounts do not tend to have a cap on how much you can save in them. You are generally free to place as much as you like within the account, though it’s worth bearing in mind that the Financial Services Compensation Scheme only protects the first £85,000 saved in each financial institution in the event that it goes bust.

The case against traditional savings accounts

Once you start to build a larger savings pot ‒ particularly if you are a higher-rate taxpayer ‒ you’re far more likely to have to hand over some of the returns to HMRC.

AJ Bell recently calculated that higher-rate taxpayers will start paying Income Tax on their interest once they have £21,250 in an easy access account ‒ based on that account paying 2.35%. Basic rate taxpayers, on the other hand, get up to £42,500 before their savings are subject to tax.

It becomes even more pronounced if you opt to lock your money up for a longer period, therefore qualifying for a higher interest rate. For example, higher-rate taxpayers who took out a one-year fixed-rate account paying 4.11% would only need to have £12,175 in the account before they had to start paying tax on the returns.

If interest rates on savings accounts continue to rise, more savers with traditional savings accounts will find their returns are taxed.

Why choose an Isa?

Isas allow savers to enjoy the full fruits of their saving efforts, entirely tax-free. As a result, if you have a significant savings pot then an Isa is bound to appeal, although there is an annual Isa allowance ‒ currently set at £20,000 for the 2022/23 financial year. Another positive is the variety in the type of Isa available. 

• If you’re a saver who wants some low-risk certainty then you can put your money into a Cash Isa, which works exactly like a traditional savings account except that the returns are guaranteed to be tax-free.
  
• If you’re happy to accept a little more risk, in return for the chance of higher returns, then you could opt for a Stocks and Shares Isa. The types of investment that can be held within a Stocks and Shares Isa varies based on the provider, but it allows savers to enjoy every penny of the returns generated from individual stocks, funds, bonds and the like in their Isa.
  
• Alternatively, there is the Lifetime Isa. This is aimed at two distinct types of saver: those looking to build up a deposit to use when purchasing a house, or those who want to save for retirement. The money you save in a Lifetime Isa is eligible for a 25% bonus from the government each year, with the bonus capped at £1,000. You must be under 40 to open a Lifetime Isa.
  
• Another form of investment Isa available is the Innovative Finance Isa, which can be used to invest in alternative assets like peer-to-peer loans.
  
• You can even use Isas to put money aside for your children in the form of a Junior Isa.

Along with the range of different types of Isa, a further plus point is the fact that your annual allowance adds up each year. If you make the most of your £20,000 allowance each year, you can swiftly build up a significant savings pot, with every penny in interest retained by you.

The case against Isas

Any unused Isa allowance cannot be carried over to future years. So, if you save less than £20,000 in any tax year, that unused allowance is gone forever. This could be frustrating if you suddenly come into a windfall – for example, a large bonus or an inheritance.

In addition, you are only allowed to open one of each type of Isa in any one tax year. While you can spread your annual allowance across different types of Isas ‒ saving some money in a Cash Isa and some in a Stocks and Shares Isa, for example ‒ you cannot open two Isas of the same type in that year.

Also, while the returns from Isas are free of tax, that doesn’t necessarily mean that you will be better off by using them. If you opt for an investment Isa (the Stocks and Shares Isa or the Innovative Finance Isa), there is the risk that the assets you invest in could lose value. As a result, you may end up with less than you started with.

Even if you stick with the security offered that’s offered by a Cash Isa, you will have to accept lower interest rates than you could get from a regular savings account. 

Moving money between Isas can also be challenging. Not all Isas accept inward transfers. This means that you cannot move money that’s already held in an Isa into them. This can mean limited choice when it comes to finding a new home for your savings. What’s more, the money must be transferred directly from one Isa to another, in order to retain its tax-free status. 

Making the most of both traditional savings accounts and Isas

There is nothing to stop savers from using both Iass and regular savings accounts. In fact, for some savers, this will make sense.

For example, if you have used the entirety of your £20,000 annual Isa allowance, then that does not have to be the limit to your saving. Once you hit that threshold you can continue to save money in a traditional savings account. 

It also might make sense to divide the money you’re saving ‒ based on whether you need to access it in the short or long term. Keeping an emergency stash of money in a standard easy-access account can make sense in order to qualify for the higher rates of interest, while you save any money that you won’t need for upwards of a year in an Isa.