Why saving is a mug's game

Inflation, taxes and low rates are slaughtering savers. We find five ways to fight back!

Around 90 years ago, Russian revolutionary Vladimir Ilyich Ulyanov declared: "The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation."

Remarkably, this anti-capitalist (better known as Lenin, founder of Soviet Russia) has almost perfectly described the problems facing British savers today.

Higher prices are killing money

Indeed, savers must have groaned on Monday (16 May), when the Office for National Statistics (ONS) revealed that the Consumer Prices Index measure of inflation rose to 4.5% in April. This is the CPI's highest level for 30 months, since October 2008.

In other words, according to the CPI figure, the cost of living today is 4.5% higher than it was 12 months ago. Another measure -- the Retail Prices Index (RPI), which includes housing costs -- hit 5.2% in April.

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Therefore, a basket of goods costing £100 a year ago now costs perhaps £105, so high inflation is eroding the value of our money over time. This is particularly bad news for savers, especially those who rely on savings interest to supplement their incomes, such as pensioners.

Rubbish rates and taxes, too

Another problem for savers is that the Bank of England's base rate is at a 317-year low of 0.5% (where it's been stuck since March 2009). With such a low base rate, it's almost impossible for savers to earn more than, say, 3% a year without locking their money away for years.

In addition, the taxman is always lurking, waiting to seize his share of our savings interest. Non-taxpayers can complete a form R85 to get their interest paid without tax taken off. Alas, the rest of us lose 20%, 40% or even 50% of our savings interest to HM Revenue & Customs.

In other words, thanks to rising prices, low interest rates and tax rises, British savers are being slaughtered in their millions. Lenin would be pleased!

Five ways to fight back

Having been battered to their knees, Britain's savers have two choices: sit back and take more beatings, or come out fighting. I favour the latter approach, so here are five ways to get 'more bang for your buck':

1. Don't pay tax

I'm not suggesting you follow in the footsteps of top hedge-fund managers by relocating to tax havens such as the Isle of Man, Switzerland or the Cayman Islands.

Instead, do what 19 million other Brits do by sheltering your savings inside the UK's most popular legal tax shelter: a cash ISA. In this tax year, which runs to 5 April 2012, anyone aged 16 or over can deposit up to £5,340 into a cash ISA, with all interest paid tax-free. By making full use of ISAs, you can keep the pesky taxman at bay forever (fingers crossed).

2. Pay off expensive debts

Let's say that, try as you might, the best taxable savings account with no strings that you've found pays an interest rate of perhaps 3%. Can you find a better home for your spare cash?

Sure you can, if you owe money on credit cards, store cards, or bank overdrafts. With typical rates for cards and overdrafts running at nearly 20% a year, it makes serious sense to use some or all of your savings to reduce your debts.

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For instance, using £1,000 of your savings to pay off a credit card charging 20% APR will save you £200 a year in interest. This switch will lose you only £30 a year in savings interest, leaving you £170 a year better off, every year.

In short, use what spare cash you can to pay off high-charging debts before adding to your savings pot.

3. Reduce your mortgage

The only way to make more than 4.5% a year after tax would be to lock away your cash for five years in a Best Buy fixed-rate, tax-free cash ISA. However, who wants to stash away their cash for half a decade when interest rates are sure to rise steeply between now and 2016?

Instead, why not reduce your home loan through one-off lump sums or monthly overpayments?

Let's say that your mortgage rate is 4.5% a year and you pay income tax at the basic rate of 20%. To earn 4.5% after tax, your savings rate would need to be 4.5% / 80% = 5.6%. (For a 40% taxpayer, this 'hurdle rate' rises to 4.5% / 60% = 7.5%. Yikes!)

In this example, paying off your mortgage faster is similar to earning over 5.6% a year on your spare cash. Before you do this, however, please check with your lender that you are free to reduce your mortgage balance without penalty.

4. Pay into a pension

Thanks to tax relief, a £100 contribution into a personal or company pension costs basic-rate taxpayers just £80. For higher-rate taxpayers, adding £100 to their pension pots costs a mere £60. Hence, you can turbo-charge your spare cash by popping it into a pension.

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However, the big downside to pensions is that you cannot touch your pot until you reach age 55. Thus, pumping up your pension is very much a long-term approach. Nevertheless, putting away as much as you can now is sure to make for a better retirement.

5. Buy shares paying generous incomes

Lastly, if you're willing to take the risk of investing in shares, then you could boost your income by investing in companies that pay generous incomes to their owners in the form of dividends. You can find out more about which shares to choose in this article on the Motley Fool website.

What's more, buying shares inside a stocks and shares ISA means paying no tax on these dividends, as well as avoiding Capital Gains Tax on your profits when selling shares.

Of course, share prices can go up and down, so you could lose money by investing in any listed company. That said, I expect the dividends paid by these companies to rise over time and, eventually, their share prices should follow.

So, please don't be a sad saver. Instead, start working your money harder right away!

More: Find splendid savings accounts today | Don’t make this stupid savings mistake | Do your bosses deserve their money?