Higher interest rates on cash mean that more savers owe tax on it
If you do not use all your Isa allowance for higher-returning investments you could hold cash within an Isa
This is particularly important for additional rate taxpayers
The increase in interest rates on cash means that it has become much easier to earn interest in excess of the personal savings allowance, which enables basic rate taxpayers to earn interest from cash and bond investments worth up to £1,000 and higher rate taxpayers up to £500 a year tax free.
With rates of, for example, 6 per cent available on one-year bonds, savings in excess of £16,666 for basic rate taxpayers and £8,333 for higher rate taxpayers would be taxable. And with some easy-access accounts offering interest rates of 5 per cent, savings in excess of £20,000 and £10,000 for basic rate and higher rate taxpayers, respectively, would be taxable.
Interest on cash in excess of the annual personal savings allowance also contributes to your total annual taxable income so could push you into a higher income tax band.
Cash Isas look increasingly attractive
“While the increase in interest rates is welcome for savers, it has caused a tax headache for many people with cash savings accounts,” says Sean McCann, chartered financial planner at NFU Mutual. “You must declare any savings interest in your self-assessment tax return. Cash individual savings accounts (Isas), on the other hand, grow tax-free and are becoming an increasingly attractive alternative for many, particularly higher rate taxpayers.”
This is especially the case for additional rate taxpayers who don’t have a personal savings allowance, meaning that all interest they earn on cash is taxable.
If some or all of your cash holdings are attracting tax you could consider holding them in Isas – as long as you have not used up this allowance to shelter higher-returning investments such as funds and direct shareholdings. “You should put your least tax-efficient assets into an Isa first,” says Sam Ratnage, wealth manager at Tideway Wealth. “Investments such as bonds and equities target higher returns than cash [so], even with [higher] interest rates, are likely to be subject to more tax than cash over time. This means that you should use your Isa allowance for these assets before you use it for cash.”
Lily Sparrow, senior investment consultant at wealth manager Moneyfarm, adds that you should consider the potential return and time horizon of an asset as Isas are most efficient when used over the long term. This is because investments within them benefit from tax-free compound interest and growth. And it is another reason why you should prioritise holding higher returning, long-term investments within Isas.
But if you don’t use all your £20,000 annual Isa allowance to shelter investments, use whatever is left to shelter cash. It’s a good idea to use up all your Isa allowance each year because you cannot carry it forward. Doing this also gives you options, for example, if want to change your asset allocation in future, you could transfer a cash Isa into a stocks and shares Isa. These investments would be immediately sheltered from tax. But if you do not take up your Isa allowance and in future decide to allocate to investments, only ones up to the value of the annual Isa allowance can be put into one each year. The more assets you move into a tax-efficient environment the sooner, ultimately the more of your assets you can shelter from tax.
Also, if you are planning to invest money within an Isa but are not sure what to put it into, rather than lose the allowance you could hold it in cash in the short term and deploy it into markets as you decide what to invest in. Or put the cash into an Isa and transfer a small set amount of it each month into investments. By doing this, when markets are down and units or shares in investments are cheaper you buy more, and when markets are up and these are more expensive you buy fewer.
Although interest rates on regular savings accounts tend to be better than those of equivalent types of Isas, the difference is not great. For example, as of 27 September, the best interest rate available on an easy-access cash Isa was 4.8 per cent and the best interest rate available on an easy-access cash account was 5.1 per cent, according to Moneyfactscompare.co.uk. So if you have Isa allowance left after sheltering investments, it is still worth using the excess allowance for cash. This is especially the case for additional rate taxpayers, and taxpayers in lower bands who have used up their personal savings allowance.
Also, some cash Isas are flexible, which means you can withdraw money from them and put the same amount back in within the same tax year without eating into your annual £20,000 allowance. This means that you could use them in a similar way to an easy-access cash account.
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