In this week's millennial money episode, I ask financial expert Damien Fahy about the difference between a Cash ISA and a savings account.
What is an ISA?
This is a question that we get asked a lot. An ISA is basically like a box that you can put money into and you can build up savings, tax free. ISA stands for 'individual savings account', there are lots of different types of ISAs but for this video, we're going to just focus on cash ISAs. If you want to read more about the different types of ISA's, you can read our article 'Where should you invest your ISA allowance'.
There is a limit on how much you can put into an ISA and it is currently £20,000 per year because there is that tax advantageous status which is £20,000 a year at the moment.
What's the difference between a cash ISA and a savings account?
It's a good question.
As we explained earlier, a cash ISA is a separate box, a savings account where any interest you earn on your money is tax-free forever. In a savings account, the interest is taxed, so as you put your money in any interest you get on top of that is subject to income tax. ISAs were only introduced in 1999 and so all savings prior to then would have been subject to income tax.
If you're a basic rate taxpayer the first £1,000 of interest you earn is free of tax (this is called the 'savings allowance'). As interest rates are so low at the moment, you would need a significant amount of savings each year to exceed the £1,000 savings allowance limit. If you're a 40% taxpayer that allowance is halved to £500 and if you are a 45% taxpayer you don't get one because let's be honest you're probably rich enough.
So with a cash ISA any interest you earn is tax-free forever and with a savings account it's tax-free to a point and once the interest you earn exceeds £1,000 a year then you are taxed on everything above that.
Savings account vs ISA
If you are saving for short term events or a rainy day then you might prefer to save in a savings account because you're probably not going to exceed the £1,000 savings allowance and you can ensure that you have immediate access to the money should you need it. There's also a quirk where the savings rates on savings accounts tend to be a little more generous than they are on cash ISAs. Simply select the account that offers the best rate, but beware of withdrawal restrictions and also limited offer deals (where the rate drops after a year) Do your research and set a diary reminder if the rate is due to drop in the future. Check out our article on the best easy access savings accounts.
Why would I get a cash ISA if it has a worse savings rate than a savings account?
Cash ISAs are good if you're trying to build something over time. Let's dream and say that we were able to put in the full allowance of £20,000 a year; and there are people who do, they put in £20,000 into their cash ISA year on year. There are people that have managed to amass as much as a million pounds in a cash ISA and all of the interest they earn is completely tax-free, meaning the taxman will never be able to touch it.
Whereas if that same person has put all of that money into a savings account, you could see that they would only be allowed to earn £1,000 in interest tax-free and the rest would be subject to tax.
So the big difference between a cash ISA and a savings account is the fact that your cash is tax-free forever with a cash ISA but on a savings account, there is a limit. If you are interested in finding out more about cash ISAs and what are the best cash ISA rates then you should read our article 'best fixed rate cash ISAs'.
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