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

Savings accounts are starting to look more attractive amid the Bank of England (BoE) base rate hikes.

The interest rates offered on the best savings accounts are slowly rising, with the top rate for an easy access account  now close to 5%.

That beats many Isa best buys, which may make some wonder if they are better off sticking with their savings, even though it could mean you pay tax on your earnings. 

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The paltry interest rates on offer from savings accounts of all kinds over recent years have already dented the appeal of cash Isas, as most regular savings accounts have allowed savers to earn some level of interest tax-free before hitting the personal savings allowance threshold. 

But with the increasing rates we’ve seen in recent weeks, albeit at a snail-like pace, the situation for savvy savers has changed. 

We look at what savers need to consider when deciding between a traditional savings account and an Isa.

Why choose a traditional savings account?

Savers making use of cash savings accounts have particularly benefited from the combination of low-interest rates and the personal savings allowance. 

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 may 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 top regular easy access account today pays a rate of , more than the 4.43 % 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.

Unlike Isas, traditional savings accounts do not tend to have a cap on how much you can save in them. You can put in 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 earnings to the taxman, particularly as savings rates rise.

AJ Bell recently calculated that higher-rate taxpayers will start paying Income Tax on their interest once they have £11,700 in an easy access account ‒ based on an account paying 4.3%. 

Basic rate taxpayers, on the other hand, get up to £23,300 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 5.8% would only need to have £8,650 in the account before they had to start paying tax on the returns. Basic rate taxpayers would get up to £17,250 before their savings are subject to tax.

If interest rates on savings accounts continue to rise, more savers with traditional savings accounts will find their returns are taxed as they will earn above the personal savings allowance.

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 2023/24 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 and if you’re using a Lifetime Isa to save for retirement you won’t be able to access the cash until age 60 without incurring a penalty.
  
• 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.

 If you can make the most of your £20,000 allowance each year, you can build up a significant savings pot, with every penny in interest retained by you. 

Additionally, you can benefit from moving Isa savings from previous years to accounts that allow transfers as rates rise, while preserving the tax-free status.

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 by a Cash Isa, you will have to accept lower interest rates than you could get from a regular savings account and potentially from investing in the stockmarket.

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 Isa 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

Another factor to consider is inflation, while it may be worth keeping your money you need access to in a cash savings or Isa account, Moneyfacts highlights that none currently beat the cost of living measure. If you want to keep up with or beat inflation and don’t need access to your cash straight away, you may be better off taking more risk with your money by investing. 

You can still do this with a stock and shares Isa where the returns are tax-free and you could beat the returns you would get from cash and hopefully outperform inflation over the long-term.

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