Savings account Guides

Interest on ISAs vs. standard savings accounts

By Hazel Cottrell hazel.cottrell@consumerchoices.co.uk

Where will my hard earned cash earn more interest, in a savings account or a in cash ISA? (Updated 6/10/09)

When comparing the difference between an ISA and a normal savings account, an ISA offers you one crucial benefit - you don’t pay any tax on the interest that you earn.

But how does this work in practice? We take a closer look…

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• Cash ISAs
• Savings accounts
• Where will my money earn more interest, in a savings account or a in cash ISA?
• Case study
• Our recommendation

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Cash ISAs

A cash ISA (Individual Savings Account) is basically just a savings account on which you can earn interest without having to pay tax.

For the tax year 2009/10 which ends on 5 April 2010, if you are under 50 you can invest up to £3,600 in a cash ISA, and if you are over 50 you can save up to £5,100.

Any interest you earn on your cash ISA is completely tax-free.

For the tax year 2010/11, everyone can save up to £5,100 in a cash ISA.

Read our complete guide to cash ISAs >>>

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Savings Accounts

A savings account may offer you a slightly better interest rate than an ISA, but any interest you accumulate will be subject to tax.

The amount of tax you pay will be determined by your current rate of income tax as follows:

Rate	Tax on Interest	Tax on Income	Band (above any personal allowance)
Starting Rate	10%	10%	£0 to £2,320
Basic Rate	20%	20%	£2,321 to £34,800
Higher Rate	40%	40%	over £34,800

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Will a cash ISA or savings account earn me more interest?

The best buy cash ISA will almost always beat the best buy savings account, because interest earned on an ISA is not subject to tax.

Interest earned from a standard savings account is immediately subject to a tax of 20% if you are a basic rate tax payer or 40% if you are a higher rate tax payer.

However, all interest from an ISA comes directly to you completely tax-free and you are not required to declare any ISAs on your annual income tax return.

This means that even if the interest rate on an ISA is slightly lower than that on a savings account, it will often allow you to earn more annual interest than a standard savings account.

It’s easiest to see the effects that tax can have your savings with an example…

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Case study

Betty is a basic rate tax payer. She has £3,600 to save and has to choose between a saving account paying 6% interest and an ISA paying 5.5%.

Type of account	Interest rate	Annual interest on £3,600 before tax	Annual interest after tax for basic rate tax-payer	Annual interest after tax for higher rate tax-payer
Savings Account	6% AER	£216	£172.80	£103.60
ISA	5.5% AER	£198	£198	£198

Looking at the annual interest after tax, her decision becomes easy – she would earn more on her savings if she put them in an ISA.

For a higher rate tax payer, the advantages of an ISA are even greater. After paying 40% tax, a higher rate tax payer would only earn £103.60 a year in the savings account above, but could earn the full £198 interest in the ISA.

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Recommendation

Because all interest earned on your ISA is tax-free and you can continue to receive tax-free interest on this cash for the life of your balance, you’re generally likely to maximise returns by putting the first £3,600 of your savings each tax year into a cash ISA.

Not all ISAs will beat all savings accounts however, so it’s important to shop around to find the best interest rate.

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