How to choose between a Savings Account or Cash ISA
You have some money to put away for another day. So, open a Savings Account to keep it to one side? But then there are also Cash ISAs. Will the money be better in a Savings Account or Cash ISA (Individual Savings Account)?
What are the pros and cons? Understanding the differences between a cash ISA and a regular savings account does not have to be complex. It may be that the ISA is better for longer-term savings while the savings account is more like an interest-earning reserve for day-to-day money management. It depends on factors such as accessibility, the amount saved, and the tax implications. Each type of account has its benefits.
With the information below you’ll be better placed to match the account types to your own financial circumstances.
The main differences – Savings account or Cash ISA
ISAs (Individual Savings Accounts) in the UK are fundamentally savings accounts with special tax benefits. ISAs are savings accounts, but not all savings accounts are ISAs. The big difference is in the way that the interest they earn gets taxed, but there is more to it.
Tax on interest earned
With a savings account, the interest earned each year is taxed, but only if it exceeds a limit set by the government. This is currently £1,000 for basic rate taxpayers* and £500 per year for higher rate taxpayers* and £0 for those on the additional rate*. Interest earned above that amount is taxed at your marginal tax rate. On the other hand, all interest earned and capital gains on money saved in an ISA is tax-free, forever and regardless of your tax rate.
Savings account interest is calculated on the balance and added to the account. Any tax, if due, does not get deducted from the savings account so the compounding of interest is unaffected. The interest earned by a cash ISA is calculated in exactly the same way, with no tax implications.
Up to the point where a savings account generates more than £1,000, or £500 for higher rate taxpayers, interest per year, there is very little difference between it and an equivalent cash ISA. That’s if your savings are £20,000 at 5% or £25,000 at 4% for basic rate taxpayers, half that amount for those on higher tax bands. After that point, a cash ISA is more profitable.
You can save as much as you like each year in a savings account, from 1 penny to potentially £millions. However, depending on the account terms, the bank or financial institution may set a minimum and/or a maximum. ISAs, regardless of type, have an annual limit as to the amount you can deposit each tax year, even if you have multiple ISAs. That limit is currently £20,000 per tax year.
The interest rates paid are roughly similar for savings accounts and cash ISAs for new customers. Be aware of special terms for savings accounts, such as the need to make regular deposits or when and how often you can make withdrawals.
Also, note that the headline interest rates of savings accounts often apply for the first year only and reduce dramatically from the second year onwards. Switch the money to a new savings account immediately at that point to maintain the higher rate. It’s a hassle and can lead to a significant loss of interest if you forget. This typically does not happen with cash ISAs.
The bottom line
The main differences between a savings account and a cash ISA in the UK are the tax treatment, contribution limits, interest rates, and accessibility.
- Savings Accounts and Cash ISAs pay similar rates of interest
- Interest earned in a cash ISA is tax-free.
- Interest earned in a Savings account is taxable, but only if you earn more that £1,000 interest as a basic rate taxpayer or £500 as a higher rate taxpayer (in the 2022-23 tax year)*.
- So if you earn less than that amount in annual interest then there is very little difference between a savings account and a cash ISA.
- If you earn more interest than that amount in a year, or are getting close to it, then consider a Cash ISA.
- Up to that level it is probably more important to shop around for the best interest rates and convenience in accessing your money.
Once you have saved £20,000 (the level where you are likely earning enough interest for it to become taxable) then the decision should no longer simply be between savings accounts and cash ISAs. There are more options, including other types of ISA that may provide higher returns or serve your savings goals better.
Thinking longer term?
Other types of ISAs may be more suitable
Other than cash ISAs that simply earn interest, it is possible to invest ISA money in other ways as well.
The funds can be used to buy stocks and shares ISAs, save tax-free towards a deposit for a house (using lifetime ISAs), invest in alternative financial platforms and projects (innovative finance ISAs), and help under-18 save and learn about investments (Junior ISAs).
Each type of ISA has its own rules and restrictions on contributions, withdrawals, and tax treatment, and they may be suitable for different types of investors with different investment goals and risk profiles.
- * These amounts are current for the 2022-23 tax year. Check on the UK Government website for updates to these amounts and further information.