Find out how to spot a savings account that will really earn you money, even after tax.
Here's a simple question for you: what's the point of saving? Why bother spending less money today just so you can put away money for tomorrow?
I think that the answer is deceptively simple. The reason why we put cash aside today is so that we'll have more cash tomorrow. In other words, we stash money away in the hope that our pot will be worth more in future.
However, one economic trend works against this goal. Inflation is the tendency for the prices of goods and services to rise over time. Most developed countries have some degree of inflation in their economies. The notable exception is Japan, which has experienced deflation -- falling consumer prices -- in recent years.
Thus, as the price of goods and services tends to rise over time, it's vital that the UK's cash outpaces this growth. In other words, if the value of your cash isn't growing in 'real' terms (after inflation), then your buying power will reduce over time.
However, inflation isn't the only problem that savers face, because the government must have its share. Although non-taxpayers can avoid tax on their savings interest, the reality is that most British savers lose a part of their savings interest to HM Revenue & Customs. Only about a tenth (10%) of workers earn high enough wages to pay higher-rate tax at 40%. Thus, most taxpayers pay a fifth (20%) of their savings interest to the taxman.
So, what are the combined effects of inflation and tax on our savings returns? Take a look at the tables below, which show the after-tax, after-inflation returns of various interest rates. The current yearly rate of inflation, using the Retail Prices Index (RPI) figure to this September, is 3.9%. I've used this figure in these tables:
Non-taxpayer
Pre-tax interest rate (%) | Rate after 0% tax | Rate after RPI inflation |
|---|---|---|
3 | 3 | -0.9 |
4 | 4 | 0.1 |
5 | 5 | 1.1 |
6 | 6 | 2.1 |
So, in order for non-taxpayers to earn a tiny real return after RPI inflation, their savings need to earn 4% a year gross (before tax). A significant number of savings accounts don't even pay 4% a year, so these savers are losing out...
Basic-rate (20%) taxpayer
Pre-tax interest rate (%) | Rate after 20% tax | Rate after RPI inflation |
|---|---|---|
3 | 2.4 | -1.5 |
4 | 3.2 | -0.7 |
5 | 4.0 | 0.1 |
6 | 4.8 | 0.9 |
For basic-rate taxpayers, a rate of 5% a year is needed to make a modest real return. Given that the majority of savings accounts pay less than this rate, most basic-rate taxpayers actually lose money by saving. Ouch!
Higher-rate (40%) taxpayer
Pre-tax interest rate (%) | Rate after 40% tax | Rate after RPI inflation |
|---|---|---|
3 | 1.8 | -2.1 |
4 | 2.4 | -1.5 |
5 | 3.0 | -0.9 |
6 | 3.6 | -0.3 |
So, even higher-rate taxpayers who earn 6% a year on their savings see their money shrink in real terms after RPI inflation. Tax and inflation hit these savers particularly hard.
Two clear lessons emerge from this analysis:
First, it's vital to maximise the interest rate on your savings account. At present, you should aim to earn at least 6% a year before tax. My two favourite Best Buy easy-access accounts in this category are the Icesave (6.30% AER) and ICICI Bank HiSAVE (6.41% AER) accounts.
Second, you should do your best to avoid paying tax on your savings. The simplest way to do this is to save inside a hugely popular tax shelter known as an Individual Savings Account (ISA).
>Why not raise your rate today? Visit our centres for savings accounts and ISAs to compare market-leading savings accounts.