Savings account Guides

ISAs or standard savings accounts: who pays the most?

Updated: Wednesday 15 June, 2011

You obviously want your cash to work as hard as you do - so should you opt for a high-interest savings account or a cash ISA?

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? Take a closer look and find the best account for you.

• Cash ISAs
• Savings Account
• Will a cash ISA or savings account earn me more interest?
• Case study
• Recommendation

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Cash ISAs

A cash ISA (individual savings account) is basically a savings account on which you can earn interest without having to pay tax. An ISA is a tax-free wrapper in which your savings are held.

For the tax year 2011/12 which ends on 5 April 2012, you can invest up to £5,340 in a cash ISA.

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

Read our complete guide to cash ISAs or download our complete guide to ISAs.

Savings Account

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

Savings income normally has 20% tax taken off before you receive it. This is confirmed by the entry “net interest” on your bank or building society statement.

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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 taxpayer. If you’re a higher rate taxpayer, you still get 20% deducted at source but have to declare the interest on your tax return where an extra 20% tax will be charged on the gross (before tax) interest you received, making 40% in total.

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

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

Betty is a basic rate tax payer. She has the full cash ISA allowance of £5,340 to save and has to choose between a saving account paying 6% interest and an ISA paying 5.5%.

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 taxpayer, the advantages of an ISA are even greater. After paying 40% tax, a higher rate taxpayer would only earn £192.24 a year in the savings account above, but could earn the full £293.70 interest in the ISA.

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Our 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 £5,340 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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