Don't fall for the ISA rip-off lie

Savings providers are ripping us off, offering lower rates on ISAs than on taxable savings accounts. But watch out for this lie, or your savings will suffer!

The ISA season appears to have started early this year. Those who have already got into the tax-free savings habit will be familiar with the end of tax-year frenzy: savers rush to get their applications in ahead of the deadline on 5 April, while ISA providers fight each other hard to win business.

There's still more than 10 weeks left to that all-important date, but already a host of providers have launched new cash ISAs, suggesting this season should be a good one.

Poor rates

Unfortunately, a closer look at some of today's best-buys reveals rather disappointing rates. For example, the top easy access cash ISA is the Standard Life Direct Access ISA, which offers a return of just 2.65%. This has led many commentators to the conclusion that ISAs just aren't worth it, and ISA providers are ripping savers off with appallingly low rates.

In fairness, this is a feature which applies to all sorts of savings accounts in the current low-interest environment. Nevertheless it doesn't seem like a great advert for tax-free saving when the top returns from cash ISAs look worse than the best rates paid by ordinary taxable savings accounts. The most competitive easy access savings accounts are paying more than 3% right now, so where's the incentive to put your money in ISAs?

Having said that, you should always remember that ISAs pay a tax-free return. Even when the headline rates seem lower than comparable taxable accounts, the actual amount of interest paid is greater.

Just take a look at the table below which compares the best tax-free ISA with the top taxable account with true easy access:

Taxable versus tax-free savings accounts

Of the two accounts shown, non tax-payers would actually be better off choosing Scottish Widows Bank Internet Saver in preference to the Standard Life Direct Access ISA. Savers who don't pay tax are entitled to receive interest gross - that is, without deduction of tax - by filling out HMRC form R85. This means they would earn an extra 0.36% in interest over a year.

On the other hand, basic rate taxpayers and higher rate taxpayers would be better off going for the Standard Life Direct Access ISA instead. With this ISA all savers will receive a current return of 2.65% tax-free regardless of their tax bracket. 

But basic rate taxpayers who open a Scottish Widows Bank Internet Saver will only earn a net return of 2.40% once 20% tax has been deducted. While higher rate taxpayers will get an even worse rate of just 1.80%, with a 40% tax deduction.

For the Scottish Widows account to beat the returns from the Standard Life ISA, it would need to pay a gross rate of more than 3.31% for a basic rate taxpayer, and over 4.41% for a higher rate taxpayer.

In these circumstances, the Standard Life Direct Access ISA would be a far better choice for any tax payer. Of course, if you've already used up all your cash ISA allowance for this tax year (you can save up to £3,600 a year rising to £5,100 from 6 April, while the over fifties can save £5,100 now) and you need easy access to your savings, the Scottish Widows Bank Internet Saver would be a good option.

ISA transfers

So far we've look at the best home for your ISA savings for this tax year. But what about your old ISA cash? Did you know you could step up your return by switching into a best-buy ISA which accepts ISA transfers?

The Santander Direct ISA is a great choice with a market-leading rate of 3%. To earn this return you'll need to open the account with a minimum balance of £9,000 (balances below this amount earn just 2%). You should remember the rate includes a 2% bonus which disappears after 12 months. So, the chances are, you'll need to transfer your ISA savings again at this time to keep on earning the most competitive rate.

Why ISAs still make sense

There's no escaping the fact that savings rates are low across the board, and with inflation creeping upwards, the situation is worsening. That said, I still think it's a good idea to use up as much of your ISA allowance as you can possibly afford.

Think about it this way: at some point the financial crisis will normalise, the base rate will increase and savings rates will improve. When this happens, you'll be in a great position to transfer all your ISA money to the market-leader at that time, where you'll enjoy a much healthier tax-free return on more of your cash. Remember any allowance you don't use up by the 5 April deadline each year will be lost forever.

So if anyone ever tells you ISAs are a rip-off right now - put them straight. You're not only saving tax on your investment this year, you're saving tax each and every year you hold that ISA. Even if it doesn't seem worth it right now, it may well be worth it in the future.

If you have a question about tax-free saving, ask other lovemoney.com readers for help via Q&A. And join our Build up your savings goal to help you save as much as you can.

Compare ISAs at lovemoney.com

More: Top 10 cash ISAs for 2010 | Three cheap index trackers