Cash ISAs

A cash Individual Savings Account allows you to save money and receive interest free of tax up to the annual tax year investment limit set by the government. This guide explains what you need to know about how your cash ISA works and how you can benefit from a cash ISA.

What is a cash ISA?

The cash ISA is the easiest part of the whole individual savings account regime to understand. It is simply a way of saving money in an account that allows you to earn the interest generated by your savings free of tax.

That may sound like a good idea. The cash ISA is! Any taxpayer keeping money on deposit in an ordinary savings account is already paying tax on interest earned. Basic rate taxpayers see their headline rate of interest cut by 20% - tax that is normally deducted automatically from the interest paid on your savings. Higher rate taxpayers have to pay an additional 20% tax on interest income with their tax return.

However save your money in a cash ISA and the interest you earn is the interest you get and there is no further bill for higher rate taxpayers. So basic rate taxpayers are 20% better off on their tax liability and higher rate taxpayers 40% better off by putting their savings into a cash ISA. What's more you dont even have to show your cash ISA on your income tax return.

What does that mean in real terms?

Well a higher-rate taxpayer who invested a £3600 lump sum in a cash ISA at 6.0% would earn interest over a 12 month period of £216. Putting that same £3600 into a deposit account paying the same gross interest rate but on which the interest is taxed would generate a net return after higher-rate tax of just £129! 

Yet many of us dont take advantage of cash ISAs wasting millions of pounds in unnecessary tax. According to research by Nationwide Building Society a third of people who do not have an ISA save up to £1000 each year in other savings vehicles. Therefore even a basic rate taxpayer would be losing over £10 in unnecessary tax each year Source Nationwide Building Society 17/03/2008.

How much can I save in a cash ISA?

The maximum amount you can save in a cash ISA is £3600 in each tax year which runs from April 6 to the following April 5 in the next calendar year. The Government has scrapped the old distinction between Mini and Maxi ISAs. Existing cash Mini ISAs Tessa-only ISAs and the cash component of Maxi ISAs have all been reclassified as cash ISAs.

Although you may put a total of £7200 into ISAs in one tax year you may save no more than £3600 in cash. If you don't want to use your entire annual ISA allowance to invest in stock and shares ISA you may wish to consider putting your spare money into a cash ISA.

However remember that you are only able to invest in one cash ISA and one stocks and shares ISA each tax year.

For example

A saver puts £1200 into a cash ISA at the beginning of the tax year. In the same tax year he could save up to another £6000 in ISAs. This could be up to £2400 in the same cash ISA or up to £6000 in a stocks and shares ISA with either the same or another provider or a combination of both.

What happens if I withdraw money from my ISA?

Most cash ISAs will put few obstacles in your way should you wish to withdraw your money - many are instant access accounts - and you may transfer money placed in a cash ISA to a stocks and shares ISA.

However it may not really be in your interests to withdraw funds from a cash ISA too often. There is a simple reason why not. It is the contributions limit. Remember you may only put in £3600 in one tax year.

That limit is not a net figure for contributions after any withdrawals are deducted. It is a hard and fast limit. If you put in £3600 at the start of the tax year for example and then withdraw £1000 even though your cash ISA would now only have £2600 in it you may not put in any more money in the same tax year. Once you hit the £3600 limit thats that.

How do I maximise the return Im getting?

Many cash ISA providers calculate the interest on their cash ISAs annually, usually at the end of March to co-incide with the end of the tax year. It makes sense therefore to invest as much as possible either at the end of one tax year in order to take advantage of any unused allowance or at the very start of the new tax year. 

Do this and your money will be earning the tax-free rate of interest for the longest possible period before the interest calculation is actually made and the interest earned added to your account.

Drip-feeding money into the account will reduce your potential return even if over the course of the year you actually save the full £3600 compared with investing it all at the start of the year. Wait until later in the year and you also reduce your likely return. Invest that full amount as a lump sum half way through the tax year say in October and you will halve your real rate of return.

However whether you can afford to deposit £3600 at the start of the tax year or are only going to make deposits as and when you can a cash ISA makes more sense as a home for your money than an ordinary deposit account. But do be aware that depositing even just £1 in a cash ISA immediately limits the amount you may invest in stocks and shares in an ISA in the same tax year.

Do I have to be over 18 to have a cash ISA?

The minimum age at which you may set up an individual savings account is 16 years old.

However 16-18 year-olds may not invest in stocks and shares ISAs but are only allowed to open a cash ISA so their annual ISA contribution limit is £3600. This means a potential £7200 of tax free investment could be made before the age of 18.

Why do I need to keep track of the interest rate?

The rate paid on your cash ISA will certainly look more attractive than the rates on offer for ordinary savings. However you should take care to understand the way the interest rate is operated. For example if you are likely to want no-notice penalty-free access to your cash ISA savings you may not find it available from the ISA provider offering the highest rate of interest.

Furthermore the very best rates may only be available to savers willing and able to deposit the whole £3600 annual cash ISA contribution limit as a lump sum. Get past that hurdle and there are still others to face. You may find that the headline rate of interest includes a so-called loyalty bonus that you will only get if you make no or only very limited withdrawals in the first 12 months. Break the withdrawals limit and your rate of interest earned could drop sharply.

Be wary too of headline-grabbing bonus interest rates that may not last the whole year. You may also find that your custom is turned away by some ISA providers notably some of the smaller Building Societies which may limit their account offerings to existing members or perhaps only those within a certain catchment area usually their county of origin.

Clear all these obstacles and still you will need to keep an eye on the interest rate you are earning. What happens if you take out a cash ISA account with an institution that pays a market-leading rate only to find it slipping down the league tables in later years? What can you do? Move your ISA savings to an account that pays more interest is what you can do. But if you do decide to take your ISA savings elsewhere make sure you follow the switching rules or you could lose the tax-free status of your money.

First of all make sure the provider you want to switch to takes transfers as not all of them do. Remember also that if there is any account notice period on your current ISA you should comply with it or you may lose interest due.

The key point to remember is that your cash ISA must be transferred directly between the two providers. You cannot personally transfer your ISA by closing it and opening a new ISA with the new ISA provider. Do this and you lose the tax-free status of your existing savings.

All you need to do once you have decided to move your cash ISA is ask your new plan manager for a transfer form. Once you have filled the form in give it to your existing ISA provider who will arrange the transfer for you. This is essential to maintain the tax-free status of your money.

Can I easily switch ISA providers?

Yes, but do NOT simply close your existing cash ISA and don't take a cheque from your old provider to the new one - doing so counts as a "withdrawal". If you have been saving for some years the amount involved could easily be well over the £3600 annual contribution limit and all you will have succeeded in doing is losing the tax-free interest status of the money you have already saved. Furthermore any deposit you may attempt to make with the new provider would be limited to your ISA tax year allowance.

Contrary to previous rules your ISA savings do not necessarily have to stay in the same components. You may transfer funds from a cash ISA to a stocks and shares ISA but not vice versa.

For example

A saver has a total of £9000 in cash ISAs from previous years. He plans to invest his full current year ISA allowance of £7200 in a stocks and shares ISA. In the same tax year he could also transfer some or all of the £9000 held in cash ISAs to any stocks and shares ISA.

You will need to check your terms and conditions to see whether your existing ISA provider has imposed any limitations on transfers.

Beware of penalties. You may be subject to a penalty by your existing ISA provider. If you decide you do wish to transfer your savings from one ISA account provider to another you must allow the account providers to do the transfer for you. This way the tax-free status of your savings will be preserved.

2009-03-09 16:50:53 © Moneyextra.com