ISAs vs Regular Savings Accounts
Following the 2014 budget and the resulting changes to the ISA rules, there has been much debate surrounding the benefit of ISAs. In this low interest rate environment, many people have argued that they can obtain better returns in non-ISA accounts and therefore it is better to save their money outside of an ISA. This article will hopefully show that, in 99% of cases, this is wrong.
Benefits of an ISA
Before we look at some examples, its worth reminding ourselves of the key benefits of an ISA. Interest returns are tax free in the current year and, more importantly, interest returns are tax free EVERY year into the future.
A limited amount can be contributed into an ISA each year (the limit for 2014/15 will be £15,000 after July 2014) and this money can be removed at any point.
Current rate comparison
For stocks & shares ISAs (long-term investments) the absolute returns (before tax impact) will be the same between an ISA and non-ISA account. We shall assume this as the FTSE 250 long term average of 10.9%.
For cash ISAs (short-term savings), an easy-access ISA is available from the Nationwide returning 2.5% AER. Equally, if you can guarantee an even monthly deposit of £1,250 and make no withdrawals, there is a 3% AER available from Newcastle Building Society.
Savings rate can be somewhat higher in non-ISA accounts. The Santander easy access account offers 3% on balances between £3k and £20k, with a £500 minimum monthly deposit and a £2 per month fee.
Seems strict, but First Direct offers an even better rate if you can match certain criteria. For monthly deposits between £25 and £500, you can earn a whopping 6% AER. However, if you miss a deposit, or make a withdrawal in the year, the account will be closed and will only pay 0.9% interest. Pretty harsh!
To understand which account is best for you, you will need to run your own calculations based on how much you are saving each month and over what period you intend to save.
However, as the following examples suggest, an ISA will usually be better for you. Let’s look at an example, which shows that in almost all cases, the ISA saving is better.
Saving a deposit for a house
In our first example, we shall assume that you are saving for a deposit on the average first time buyer London new-build property (without taking advantage of the help-to-buy scheme). A 20% deposit for this property means that we will need a deposit of £63,608, plus stamp duty of £9,541. With legal fees and other moving costs, let’s say we are looking to save £80,000 for our house.
Let’s assume that you can save £10,000 per year (£833 per month) for 8 years towards this deposit.
Therefore, even though the Santander account appears to pay a higher level of interest (3.0% vs 2.5%), the net position after tax is in the ISA account. This adds up over time and you can earn 37% more interest as a higher band tax payer by saving in your ISA rather than the non-ISA account.
Required non-ISA savings rate
As you can see, the ISA account is better than the non-ISA savings account in this example. From a mathematical basis, the better account is essentially determined by your “after-tax” interest rate. To work out yours, take you non-Isa savings rate and multiply by 0.8 for a lower band tax payer and 0.6 for a higher band tax payer.
Using the 2.5% ISA interest rate as the basis, your required savings rate would need to be over 3.125% for a lower band tax payer and 4.17% for a higher rate tax payer.
However, this is not the only thing to consider.
Maximizing ISA contributions
One very important thing to remember is that the benefit of the ISA isn’t just in the current year, but in every year in the future. Therefore, whilst some savings rates are currently higher today, this may not always be the case.
One big factor is the “use it or lose it” nature of ISA accounts. The annual contribution limit is £15,000 per year on which you can earn interest tax free for life. However, this cannot be carried forward to the following year and if you don’t use you allowance, there is no opportunity to use it again.
Therefore, for anyone who is able (or will be able to invest) more than £15,000 in any year, then it is important to use this contribution.
Longer term investments
The above analysis looks at cash ISAs. However, anyone looking to invest for the long-term (over 8-10 years) should not be putting their money into cash. For an explanation why, I would encourage you to look at the figures and statistics in:
Therefore, if you are investing in the stock market as a longer term investment, your decision is easy. The returns you receive inside or outside an ISA are the same. However, your gains, both capital gains and dividends (equivalent of interest) will be taxed if they are not within an ISA account.
Therefore, your returns will be 20% or 40% lower if invested outside of an ISA.
You should run your own figures. If you are only saving for one year, and you don’t think you’ll be hitting you annual allowances, then maybe specific non-ISA savings accounts are for you. However, for almost everyone else, an ISA will be a better place for your cash.