As our Rates Rundown summarises, best buy savings rates are continuing their rapid increase, which is great news for savers as the bite of the rising cost of living really takes hold. However, this does mean that more and more people will find themselves paying tax on their savings again as the Personal Savings Allowance is used up with smaller and smaller deposits. So, cash ISAs may become more en vogue once again. But how do the rates stack up?
What is the Personal Savings Allowance?
The Personal Savings Allowance (PSA) was introduced in April 2016 and basically means that for basic rate taxpayers, the first £1,000 of savings interest is tax free. For higher rate taxpayers it’s £500, while additional rate (45%) taxpayers, do not receive a PSA at all.
When introduced, it was estimated that 95% of cash savers would no longer pay any tax on the interest earned on their savings accounts – but that is changing rapidly as savings rates rise.
In April 2016, the best easy access account on the market was paying 1.45% - so a deposit of £68,966 would have been needed to breach the PSA (assuming no other savings accounts were held). But as rates fell after we went into lockdown, with rates as low as 0.45% a whopping £222,222 would have been needed to produce £1,000 in interest. Today, the best easy access account is paying 2.75%, so only £36,364 will breach the PSA – that’s a dramatic change.
Those who opened a 1-year bond a year ago could have deposited £74,074 before the PSA was breached as the best rate was 1.35%, but today, with the best 1 year bond paying 4.55%, just £21,979 will see the saver breaching the PSA and therefore paying tax on any excess.
Have ISA rates been improving?
The introduction of the PSA meant that interest in the cash ISA waned – savers no longer needed them, so providers no longer focused on them. But with savings rates on the up, more and more people will surely turn back the humble cash ISA, in order to shelter their interest from the taxman.
And the good news is that while the best cash ISA rates still lag behind the gross rates of the best non ISA accounts, they have been recovering fast.
Before the Bank of England started to raise the base rate, average 1-year fixed rate bonds were paying 0.66% - today it’s 2.65%, an increase of 302%! But average cash ISA rates have increased by a higher percentage, 338% from 0.58% to 2.54%.
And what is key, is that although for a while the net rate of the top fixed rate bonds (so the rate after the deduction of basic rate tax) was still higher than the tax free rate of the equivalent cash ISA, that is no longer the case. So as your Personal Savings Allowance will be fully utilised with a far smaller deposit, ISAs will become far more helpful once again in producing as much interest as possible.
For example, as we’ve mentioned a basic rate tax payer would fully utilise their PSA with a deposit of just £21,979 into the top 1-year bond paying 4.55%. After tax has been deducted, 4.55% would fall to 3.64% - whereas the top 1-year ISA is currently offering 3.85% tax free.
So as long as the ISAs pay a tax free rate that is at least higher than the rate after the deduction of tax on the equivalent non ISA accounts, then ISAs will once again become a tax haven for savers. Let’s hope the recovery continues.
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