The best new tax-free savings accounts

With prices rising fast, protect your nest-egg using one of these tax-free savings accounts...

Here’s a less than entertaining magic trick that we’re all performing every day.

If I stash a £20 note under my bed for three months, when I finally recover it – it will miraculously be worth less. Well, I say worth less – it will still obviously be a £20 note, but the amount of goods and services it can purchase will have decreased.

Why?

Inflation, that’s why.

Inflation is a general rise in prices and is measured by the Consumer Prices Index (CPI) and the Retail Price Index (RPI). And unfortunately for bed-stashing savers it’s been running at an extremely high level recently, eroding away the spending power of any money kept in cash.

But there is some good news. Inflation did actually drop between May and June with the CPI dipping from 4.5% to 4.2% and RPI dropping from 5.2% to 5.0% (for the difference between CPI and RPI head to the Office for National Statistic site). However this is still a very steep rate, considering the Bank of England target figure for inflation is set at 2% CPI.

Luckily, there are a few ways you can fight back against this eroding force...

Inflation smashing ISAs

By stashing away your nest-egg in a savings account, you can use interest payments to offset the impact of inflation. Now, there a few regular savings accounts with interest rates in excess of the CPI figure of 4.2%. However, these are all taxable. And when you deduct income tax, the real return you receive from the accounts will always be less than inflation.

A way around this is to go for a cash ISA. ISAs pay interest tax-free, so the interest rate you see is exactly what you get.

And the good news is that the cash ISA market has been quietly improving over the last few months, and there are now ten accounts that boast an inflation-beating interest rate:

Source: Moneyfacts.co.uk and lovemoney.com ISA centre

As you can see, if you are prepared to lock away your cash for a full five years – and can make an initial investment of £5,340 – you’ll be able to earn 5% on your savings using Coventry Building Society or Stroud & Swindon’s five year fixed deal. This will keep you ahead of both CPI and RPI.

However if you do plump for one of these accounts you will need to make the full initial deposit straight from your own pocket – as transfers in from other ISAs are not allowed. This minimum amount of £5,340 is also your total cash ISA allowance for the full financial year, so you won’t be able to make any other ISA deposits until April 2012.

If this account isn’t suitable for you, then BM Savings are offering a CPI-busting ISA paying 4.65% with a lower limit for investments of only £500. And what’s more, the account does accept transfers in. The Clydesdale and Yorkshire Banks are not far behind with a five year deal offering a return of 4.50%, followed by Bank of Scotland and Halifax’s 4.30% four year account.

Downsides

Obviously to get an inflation-busting return on your cash ISA investment you will need to lock up your cash for a lengthy period of time. This could be a risky strategy if the financial climate starts to flutter.

There’s been much debate recently on when the Bank of England will up the Base Rate from its current historic low of 0.5%. Some are predicting rises in the coming months while others don’t see it moving before the end of the year. However it is almost certain that within the next two years, the Base Rate will rise. And when this happens, the savings markets will change considerably as banks increase interest rates to reflect the change (or that’s the theory anyway!).

Unfortunately, this means that if you lock into a lengthy deal, you could be stuck with a paltry interest rate in a newly re-energised market.

Rising prices are a further threat. Inflation has been fairly unpredictable recently – increasing some months, and dipping the next. Indeed, just because CPI took a slight dive in June, certainly does not guarantee that it will keep dropping in July and August. So if you’ve locked into an account with an interest rate only just teetering above the 4.2% level of CPI and inflation rises suddenly, your account may quickly be stripped of its inflation-busting credentials.

But there is one way to fight back against fluctuating inflation levels...

Link it up

Inflation Linked Bonds pay a set amount of interest above the RPI index of inflation – a higher figure than CPI. So if inflation rises, so will your interest rate.

There are a few of these deals around at the moment with the market leader being NS&I’s Savings Certificates. These government-backed accounts offer an interest rate of 0.5% over RPI and – although they are not ISAs – pay out tax-free. To receive the full level of interest you will need to lock away your savings for five years, however you can still withdraw funds after the accounts first year without incurring any penalty.

Head over to New inflation-linked bond to rival NS&I to read my comparison of these savings certificates with the Post Office’s inflation linked offering.

A further option is the recently returned inflation linked bonds from BM Savings. These offer a 0.50% above RPI rate if you lock in for five years or 0.25% if you only opt for three years. Both accounts have a minimum deposit of £500 and levy a 5% penalty on any withdrawals made throughout the account’s life. The difference is that the NS&I account offers a tax-free return - without affecting your ISA allowance.

12 top tax-free cash ISAs

And finally, if none of the above accounts tickle your fancy, here are 12 other top fixed and instant-access cash ISAs...

More: Get an inflation-busting ISA | 15 top cash ISAs | 16 top cash ISAs for transfers | Banks are stealing your tax relief