For the first time in years, it feels as though there is a proper ISA season for cash savers. As interest rates have risen, the need for ISAs has re-emerged, as more and more people are paying tax on their savings interest once again. And the good news is that cash ISA rates have been far better at keeping up with standard savings accounts, which has narrowed the infamous gap.
This has seen a surge of deposits into this stalwart of the savings market.
In the final three months of last year £1.98 billion more went into ISAs than was taken out. Over the same three months of 2021 savers pulled a net £2.68 billion out of their ISAs, according to the Bank of England and there is now more than £290 billion earning tax free interest.
Why did cash ISAs fall from favour.
The Personal Savings Allowance (PSA) was introduced in April 2016 and this means that basic rate taxpayers can earn £1,000 a year in savings interest, before having to pay tax. The allowance is £500 a year for higher rate taxpayers – and there is no allowance at all for additional rate taxpayers.
So, with interest rates at the low levels they were when the PSA was introduced, it was estimated that 85% of savers would no longer pay tax on the interest from their cash savings, even outside an ISA.
This made the need for cash ISAs far less important and the rates on offer waned as there was very little competition, which is what is needed to push rates in the right direction. Even the ISA season, which is traditionally around the end and the beginning of the tax year, became almost nonexistent. As a result, a huge gap existed between the best ISA rates and the best standard accounts; in some cases those who did pay tax were still better off with a fixed rate bond rather than an ISA, making ISAs even less popular.
However, following 10 Bank of England base rate rises in a row taking the base rate from 0.1% to its current level of 4%, savings rates have improved substantially too and the interest that can be earned is at its highest level for well over a decade. And that means that savers are paying tax again – so ISAs have become far more necessary.
In March last year, the top 1-year bond was paying 1.48%, so a basic rate taxpayer would have needed a deposit of £67,568 to breach the PSA. But with the best rate today paying 4.30%, just £23,259 will earn £1,000 in interest.
Mind the gap?
For many years now, with the rates on Cash ISAs becoming so uncompetitive, the gap between the top ISA rates and the top non-ISA rates grew so large that basic rate taxpayers would have been better off even after the deduction of tax, outside of an ISA. For example, in January last year the top 1-year Fixed Rate Bond was paying 1.41% before tax, while the rate after the deduction of basic rate tax would fall to 1.13%. At the same time, the top 1-year Cash ISA was paying just 0.98%.
Today though, as the chart below shows, not only are rates across the board much higher, but the gap has definitely narrowed considerably. The best 1-year bond rate of 4.30% AER would drop to 3.44% after 20% tax. However, you can earn more than 4% on the best 1-year ISAs. So it now makes complete sense to consider a Cash ISA in order to protect yourself from paying too much tax on your savings interest, both now and in the future.
Use it or lose it
Unlike contributing into a pension, the ISA allowance is a use it or lose it one. So, if you miss the ISA deadline of the 5th April, you cannot go back and utilise it at a later date. It therefore makes sense to open a new ISA as soon as possible. This will also see you earning tax free interest for the whole tax year, rather than just at the very end. And with a healthier looking ISA season which traditionally runs from around February to mid-late April, you can hopefully grab a rate that will look competitive going forward.
Of course, it’s not just about using your current allowance either. With rates at a far more competitive level, it makes sense to review old ISAs too and transfer them if you could be earning more tax-free interest elsewhere. But remember the golden and very important rule of moving your ISA. If you want to switch, you must not close your existing ISA as that will likely mean losing the tax-free benefit.
Instead, you need to approach the new provider you wish to move to and complete the cash ISA application and transfer forms. They will then contact your existing provider and arrange the transfer for you.
Of course, finding the most suitable cash ISA for you is the key to success and this is where we can help. Check out our independent best buy tables for the top rates on offer for both your new subscription and for any old ISAs you are looking to transfer.
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