Paying less tax with cash ISAs
Last updated on 6 April 2016
What cash ISAs are
Cash ISAs are tax-free savings accounts.
They are offered by banks, building societies and other financial organisations and can be operated via a branch, the internet, by phone or post. There are limits on how much you can save each tax year.
For many years, cash ISAs have been the obvious choice for anyone looking to save as they protect your savings from tax. Ordinary savings accounts used to automatically pay any interest with 20% tax taken off. Higher rate taxpayers then had a further 20% tax to pay while top-rate taxpayers had another 25% to pay. Non-taxpayers had to go to the bother of reclaiming overpaid tax using form R40 or had to complete form R85 to get the interest paid without tax taken off.
However, changes which came in on 6 April 2016 have made the choice between a cash ISA and an ordinary savings account less clear. Basic-rate and higher-rate taxpayers now have what is known as a Personal Savings Allowance (PSA). This allows basic-rate taxpayers to earn up to £1,000 in savings income a year tax free while for higher-rate taxpayers the limit is £500. Anyone with a total taxable income of less than £17,000 pays no tax on any of their savings.
Is it still worth having a cash ISA?
Cash ISAs may seem a lot less attractive than they once were. But there are reasons why you might still want to consider one:
- Savings in a cash ISA are always protected from tax. So you can build up a large amount over time and they’ll remain tax free.
- The PSA seems generous now because interest rates are low. A basic-rate taxpayer earning 2% interest would need around £50,000 of non-ISA savings before they’d have to pay interest on their savings. But remember that if interest rates go up then you’d reach the PSA with a lower amount of savings.
- Your PSA drops suddenly by a half if you become a higher-rate taxpayer and then disappears altogether for additional-rate taxpayers. So if your income rises in the future, savings that were tax free may become taxed.
- Spouses can inherit their partner’s ISA which means the money stays protected from tax. You can’t inherit someone’s PSA.
- Additional-rate taxpayers don’t have a Personal Savings Allowance, so for them cash ISAs are still an important way to save tax.
As well as weighing up these factors, don’t forget to compare the interest rates on cash ISAs and ordinary savings accounts.
How cash ISAs work
There are instant access, notice and fixed-term cash ISA accounts. Some pay a variable rate of interest others a fixed rate.
Some fixed-rate cash ISAs are confusingly called bonds. You may not be able to withdraw money from these before the agreed time apart from in exceptional circumstances or you may have to pay penalties such as the loss of 90 days interest.
You can invest a lump sum or make regular payments into a cash ISA. Some require a minimum deposit of say £500, others can be opened with as little as £1.
How much can I invest in ISAs?
Each tax year you have an ISA allowance. For the 2016-17 tax year (6 April 2016-5 April 2017) this is £15,240. You can invest up to this amount in a cash ISA, a stocks and shares ISA or a combination of the two. For example, you could
- save up to the whole £15,240 in a cash ISA, or
- invest up to the whole £15,240 in a stocks and shares ISA, or
- save some of the £15,240 in a cash ISA and invest the rest of your allowance in a stocks and shares ISA.
You can only put new money into one cash ISA and one stocks and shares ISA each tax year.
Since 6 April 2016 cash ISAs have become more flexible. The government now allows you to withdraw money and then pay it back in later in the same tax year without it counting towards your annual ISA allowance. But ISA providers don’t have to offer this flexibility, so check with your provider.
You must be 16 to open a cash ISA. Young people aged 16 and 17 can contribute to both a cash ISA and a Junior ISA (JISA). But if a parent gives their 16 or 17 year old child money to invest in an adult ISA, and the interest earned from the gift is more than £100, then the income is taxed at the rate the parent pays on their savings. However, if the interest falls within the parent’s PSA, there will no tax to pay by the parent either.
Once a child reaches 18, their Junior ISA is transferred into a normal ISA (without using any of their ISA allowance for that tax year) and they cannot contribute to a Junior ISA any longer.
Finding the best rates
There are hundreds of cash ISAs so you might first want to consider:
- how you operate the account such as via a branch or online
- if you want to save regularly or invest a lump sum. Many fixed-rate deals are only available on the initial lump sum invested how quickly you might want to get at your cash.
It's worth keeping an eye on how much interest your cash ISA is paying. What's good one year may not be the next and you may want to transfer to a better paying account.
To transfer from one cash ISA to another, simply contact the new provider and tell them you want to transfer into their cash ISA. It's very important to let them do the transfer for you as if you withdraw the money yourself it will lose its tax-free status. This type of transfer should take no more than 15 working days of you requesting it.
You can also transfer money in a cash ISA to a stocks and shares ISA and vice versa. These types of transfers must usually be completed within 30 working days of you requesting them.
You can transfer all or part of the money from a previous tax year's ISA (that includes old ISA accounts you have) to another ISA without it affecting how much you can save in the current tax year.
If you want to transfer savings you've made in this tax year to another ISA, you must transfer the whole amount.
Spouses and civil partners can inherit their partner’s ISA tax benefits. This means when your partner dies, you get an additional one-off ISA allowance up to the value of your partner's ISA savings at the time of their death.
For example, Richard dies in May 2015 leaving £50,000 in his ISA. As a result, his wife can pay in up to £65,240 into an ISA for the 2016-17 tax year (£50,000 plus her own ISA allowance of £15,240).