Cash ISAs are the same as normal savings accounts with one key difference: there is no tax to pay on interest earned.
With non-ISA accounts, income tax is charged on interest at 0%, 20%, 40% or 45% depending on the saver’s tax bracket.
Rates on cash ISAs are usually more or less the same as those available on cash savings and deposit accounts offered by banks and building societies. But with interest rates in general having fallen sharply since the financial crisis in 2008, returns are at present significantly lower than before the crisis.
An economic downturn in the UK following the financial crisis forced the Bank of England to cut the base rate to an all-time low of 0.5% in early 2009: as a result, the average interest rates paid on all kinds of savings accounts has slumped.
By the end of last year, average rates on cash ISAs had fallen to their lowest level since 2007, and were down almost 50% on two years earlier, according to analyst Moneyfacts.*
Many savings accounts, including cash ISAs, pay less than the 0.5% base rate. A study published by the Financial Conduct Authority found that in 2013, around £160 billion of the money in easy-access savings accounts earned 0.5% or less.**
* Moneyfacts.co.uk
** FCA.org.uk
There are strategies that can help reduce the risk in investing.
Firstly, choosing a fund, which holds many different shares, perhaps as well as other assets such as corporate bonds, can be less risky than investing in one or two companies’ shares. This is because it is less likely that all the shares held by the fund will fall in value at the same time.
Paying into the ISA on a monthly basis can also cut risk: if you put a large one-off lump sum into an investment fund, there is a chance that you are buying when its value is about to fall. In this case, your investment will shrink, in the short-term at least.
Drip-feeding your money into the ISA, on the other hand, means that some months you will be buying when the market is about to fall and some months when it is about to rise. This can help to smooth your overall returns.
Bear in mind also that there are thousands of potential investments to choose from – some, such as funds which hold shares in larger, more established companies carry lower risk than funds which invest exclusively in new, high-growth businesses.
Finally, there is no rule that says it is one or the other. You could decide to divide your money between a cash ISA and a stocks-and-shares ISA to reduce your overall risk.
A stocks-and-shares ISA – also known as an investment ISA – is a way of putting money into assets such as shares and investment funds while protecting any gains from capital gains tax (CGT).
Normally, any investment growth is subject to CGT at 18% or 28% for basic- and higher-rate taxpayers respectively. However there is a CGT allowance of £11,100 in 2016-17, so any gains below this amount during a tax year are free of tax anyway. Bear in mind that tax treatment depends on your personal circumstances, and tax rules may change in the future.
Dividends on stocks-and-shares ISAs have 10% income tax deducted at source, but there is no further income tax due on these payments.
When you put money into the stock market, you take on more risk than if you save in cash. This means that there is a chance that your gains will be greater over the long term than simply saving into a cash ISA, but also that you could see a falls in the value of your holdings over the period you are investing.
Your attitude to this risk plays a large role in determining whether a stocks-and-shares ISA is right for you. Stock-market investments are more suited to money which can be tied up for the medium-to-long term, usually five years or more.
This gives your investments to chance to ride out any falls in value in the early years.
Research has shown that the stock market can outperform the returns on cash over longer periods. This makes a stocks-and-shares ISA more suitable for long-term investments such as saving for retirement – although it is also worth considering a pension such as a self-invested personal pension (SIPP) for this purpose too. You can read more about saving for your future in our article: ‘7 tips for building your retirement nest egg’.
Comparative performance Average Stocks and Shares ISA versus average Cash ISA
Past performance is not a guide to future results.
Source: Moneyfacts/Lipper Investment Management. 5 year percentage growth between 1.2.2010 and 1.2.2015.
