Make the most of your ISA allowance

Cash ISAs should be the first port of call for all savers, as they allow you to escape savings tax. But which are the best deals on the market? And what should you do to make sure you get the most benefit? Find out!

You could be forgiven for wondering whether it’s worth saving at all in the current gloomy economic climate. With interest rates at an all-time low of 0.5% - keeping savings rates low - and rates on everyday debts such as credit cards creeping to historic highs, surely you’d be better off paying down debt before building a nest-egg?

Not so - not if you make the most of your annual ISA allowance. Put simply, if you invest in ISAs you don’t have to share any growth on your nest-egg with the taxman. Savings tax on an easy access savings account is currently 20% for basic rate taxpayers - and a typical tax-liable best buy savings account currently pays just 2.5% interest before tax.

With inflation currently creeping towards 3%, you can see that if your money languishes in a bog-standard savings account, your nest egg is actually shrinking in real terms. Compare that with the best cash ISAs. With an ISA, you don’t pay either income tax or capital gains tax on any interest earned and you don’t have to declare the sums held on any tax returns.

And thanks to the miracle of compound interest, that little tax break can soon add up to a sizable sum - figures from analysts Moneyfacts show that someone who made use of their total tax-free allowance since ISAs were in launched in 1999 would have amassed a savings pot of £43,200 plus a hefty sum of tax-free interest. 

That’s a big sum to shelter from the taxman. But what are the rules governing ISAs? And how can you maximise the benefits of tax-free saving?

The rules 

The amount you can save tax-free is soon set to rise to a new high. From the start of the new tax year on April 6 anyone aged 16 or over will be able to save up to £5,100 in cash in a tax-free ISA - the current limit is for cash is £3,600 for adults aged below 49 and £5,100 for those aged 50 and over. You will also be able to invest a total of £10,200 in cash and ISAs that invest in stocks and shares – find out more about investment ISAs here. 

ISAs are available online, through banks and building societies and even supermarkets. All you need to open one is a National Insurance number and proof of address. You can switch funds between ISAs within a tax year and you can make withdrawals on certain accounts without losing your tax-free status - but you may pay a hefty penalty in lost interest.

Be aware that if you make a withdrawal, you may not be able to make a further deposit if you’ve already used up your tax-free allowance for that year.

Maximise the benefits

The first way to maximise the benefits of your tax-free allowance is to only invest as much as you can afford. There’s little point in taking out an ISA if you’ll be forced to close it months later because you need cash quickly. Use free cash to pay down costly debts and squirrel away small sums each month - it’ll soon add up to a sizable nest egg.

Think carefully about finding the best rate - which isn’t as simple as it sounds when it comes to ISAs. You can transfer part or all of your funds between different cash ISAs if you want to secure a better rate, but this can be an arduous and time-consuming process - and during any delays you’ll lose out on valuable interest. Also, not all banks and building societies will accept transfers. Even so, the number of cash ISAs accepting transfers in has grown from 183 to 272 - an increase of almost 50%.

Lastly, watch out for “bonus” rates - these are headline-grabbing rates that only last for a year before reverting to a paltry return. Look for a good guaranteed rate over the longer-term instead.

Best Buy ISA deals

If you can afford to, it’s best to opt for a fixed-rate deal where your money is ‘locked away’ for a set period of time. Rates on easy access ISAs - that allow withdrawals at any time - tend to be lower than even regular savings accounts, as banks take their share of your tax-free return. In fact, the average variable ISA rate has fallen from 1.85% to 1.38% over the past year.

Fixed-rate ISAs, in contrast, are currently paying a significant 3.24% in interest on average. Among the best buys are the new Nationwide three-year fixed-rate cash Isa which pays 4.40% on balances of £1 or over and a five-year fixed rate deal available from the Clydesdale and Yorkshire Banks that both pay a market-leading 5% interest.

Fortunately, there are some worthwhile easy access ISAs on the market too - which gives you the security of being able to withdraw funds if your circumstances change. Spanish-owned Santander currently offers the best deal with its new Flexible ISA, which pays 3.5% interest (or 3% above base rate), guaranteed for 12 months. What’s more, if the Bank of England ups interest rates in the next year, the interest you earn will increase in line.

Be aware that the Flexible ISA deal doesn’t allow transfers in - and that after the first year, the rate reverts to the bank’s ‘variable rate’, which is currently just 0.5%. Another case of headline-grabbing rates not being all they seem?

A worthwhile alternative that does allow transfers in is the Santander Direct ISA 6, paying 2% interest as standard and rising to an impressive 2.75% on total balances above £9,000. A similar deal is also available from Santander-subsidiary Alliance & Leicester.

For help with saving, why not adopt our goal Build up Your Savings? Visit our ISAs section to find regularly-updated best buys and more information on tax-free saving.