Receive 9.33% A Year On Your Savings

Beat inflation and tax - and receive up to 9.33% a year on your savings!

As the sun beats down this week, I'm sure the cloudy topics of inflation and tax are far from your mind. But -- without wanting to spoil your summer party -- this is what today's Summer Lolly is all about.  

The time is right for a reminder on inflation and tax because this week, National Savings & Investments (NS&I) claim many of us still have no idea how they destroy the value of our savings.

Ask what inflation is and you'll draw a blank response from nearly one in 10 people. And NS&I found many people who do understand what it is, don't understand how it affects their savings.

How does inflation attack your savings?

Inflation happens when the average price of everyday goods and services is increasing. This means the purchasing power of your savings is falling over time. Inflation has been low over the past few years, but it is now rising fast.

The Retail Prices Index (RPI), which has measured UK inflation for decades, is currently running at 4.6% -- more than double the rate at the end of 2005. It is based on assumptions about what the average Brit buys and the average price for these items.

So, your savings are now worth 4.6% less in real terms than they were a year ago because, on average, the things you buy cost 4.6% more.

If the rate of inflation rises even more, the value of your savings will be eroded even further.

On top of that, tax can take a nasty bite out of your nest egg too.

How does tax attack your savings?

Banks and building societies automatically deduct tax from savings accounts at a rate of 20% before the interest is paid to you. But the actual amount of tax you'll pay is determined by your tax band.

If you're a non-taxpayer, you don't have to pay any tax on your interest. So you should claim back the 20% of your interest that has been deducted from the Inland Revenue.  You should also tell your bank that you can receive interest gross --which means no tax has been deducted -- by completing an R85 form. You can download the form here.

If you're a basic rate taxpayer, then the automatic 20% deduction the banks and building societies make is the correct rate for your tax band. So there's nothing more you need to do.

But if you're a higher rate taxpayer, you'll owe the revenue an extra 20% of the interest you earn on your savings, taking your total liability to 40%. Details of all your various savings accounts should be included on your tax return to ensure you pay the right amount of tax.

What impact will tax have on your savings?

Let's say you have the market-leading instant access account, from Kaupthing Edge, which pays an interest rate of 6.55%.

Non-taxpayers will receive the rate in full, beating inflation by a healthy 1.95%.  Basic rate taxpayers will get just 5.24% net, once 20% has been deducted, so they beat inflation by just 0.67% - not much to write home about. Meanwhile higher rate taxpayers will get just 3.93% net after a 40% deduction. This is 0.67% lower than the rate of inflation - so the value of their savings is being eroded, even though they put their money in the best instant access savings account on the market.

How can you beat inflation and tax?

You can beat tax and inflation pretty easily if you have £3,600 of savings or less. You can simply deposit the money in a cash ISA. This protects your savings from tax, which makes it much easier to find a savings account with instant access that also beats inflation. The HSBC cash ISA for example, pays 6.25%.

Of course, this rate isn't guaranteed to beat inflation forever. If inflation continues to rise and the rate, which is variable, falls, then your savings could be eroded.

And what if you have more than £3,600 in savings? You can still beat inflation in two ways: First, you can put your money in an account which is specifically designed to beat inflation, and second, you can open an account which pays an inflation-busting interest rate. But this could mean locking your money away for a set period.

Let's look at option one first. If you want peace of mind that the interest rate on your savings will always beat inflation, consider taking out an NS&I index-linked savings certificate. With this certificate, the value of your savings rises each year in line with inflation -- as measured by the RPI - and there's a 1% fixed bonus on top. This means your savings rate is guaranteed to be 1% above inflation.

Certificates run for three and five year terms, and you can save from £100 up to £15,000 per issue. Just don't make the mistake of cashing in your certificates early. No interest or index-linking is paid if certificates are closed in the first year.

The icing on the cake? NS&I index-linked certificates are tax-free! That kills two birds with one stone.

So, particularly if you're a higher-rate taxpayer, I think an NS&I index-linked certificate is probably the best way to beat both tax and inflation at the moment. At current rates, you would receive a tax-free return of 5.6%, which mean seem lower compared to the market-leading savings accounts - but, because the return is tax-free, it is equivalent to 7% for a basic rate taxpayer and 9.33% for a higher rate taxpayer.

That's right - 9.33%! You won't find savings rates that good easily anywhere else..