Money tip #30 – One way to protect your savings from inflation, both tax and risk free

Inflation is the enemy of savers and anyone on a fixed income. In today’s low interest world where the general consensus is that inflation could soon gate crash and spoil the party finding ways of protecting your savings against inflation is particularly pertinent.

Pensioners, in particular, who rely on the interest from their life savings in order to live are feeling the pinch and are seeing the real value of their savings diminish (the Bank of England base rate is just 0.5% while inflation is nearer 3%). But the problem is compounded for savers who pay high rate or basic rate tax on their income (which is most of us!). This is because interest on savings is taxable. Consequently the actual rate of interest you need to receive in order to beat inflation depends on your marginal rate of income tax. Below is a guide to the headline rate you’d need to secure if your savings are to maintain their value in real terms.

Inflation rate	Equivalent rate required by Basic-rate taxpayer	Equivalent rate required by Higher-rate (40%) tax payer
5%	6.25%	8.34%
4%	5%	6.25%
3%	3.75%	5%
2%	2.5%	3.34%
1%	1.25%	1.66%

So what can you do to beat inflation?

The longer you lock away your savings (with restricted access) the better the interest rate you will secure. Currently you can get a 4.75% with the Nationwide Building Society if you put your money into their 5 year fixed rate bond. But partial withdrawals are not allowed and if the account is closed early there would be a loss of interest. While this may seem a good rate, if inflation increases in the near future it won’t be. And if you are a high rate tax payer you are barely beating inflation now.

So what else can I do without taking any additional risk with my savings?

There is one other option open to savers, and that is Index-linked savings certificates from National Savings & Investments (NS&I). One attraction of Index-linked savings certificates is that they are backed by the Government which effectively means your capital is 100% safe (even safer than saving with your bank). In addition, returns are tax-free and are guaranteed to keep pace with the Retail Price Index (RPI) for a fixed term. The return is made up of a set interest rate (currently 1%) plus the RPI figure, fixed for three or five years. You can invest up to £15,000 per issue, so you could shelter £30,000 in both of the current three and five-year plans. Admittedly you do not avoid locking your money away, (much like the aforementioned Nationwide bond) and if you cash-in early you again will lose any interest. But for income tax payers, particularly high-rate ones, in today’s low interest rate world Index-linked savings certificates now offer competitive yet inflation protected returns because of their tax-free status. And don't forget most people’s investment aim is growth in excess of inflation in any event.

More information can be found at the NS&I website here.

Update May 2011 - NS&I Index Linked Savings Certificates as described  above were pulled in July 2010. They are once again available but there is now only a 5 year issue and the return is RPI + 0.5%.