Top Tax-Free Savings!
With the help of these legal tax shelters, savers can hang onto all of their interest and keep the taxman at bay.
If you're a frequent reader of my Fool articles (for which I thank you), you'll probably have noticed that I'm passionate about saving and stock-market investing.This is more than I can say for the rest of the adult population, as the savings ratio is half what it used to be. In 1995, we saved more than a tenth of our disposable income (10.2%), whereas towards the end of 2006, it was half that (5.1%). So, as a country, we're not the savers we once were, largely because of the 'wealth effect' created by a ten-year housing boom.One problem with putting cash on deposit is that interest rates are fairly low at the moment, especially once you've taken into account inflation (the tendency for the price of goods and services to rise over time) and tax. For example, basic-rate taxpayers lose a fifth (20%) of their savings interest to HM Revenue & Customs. For higher-rate taxpayers, the deduction is two-fifths (40%).Thus, if you're a higher-rate taxpayer earning 5% a year gross (before tax) on your savings pot, emergency fund or nest egg, you actually receive a mere 3% a year net (after tax). Given that one measure of inflation, the Retail Prices Index (RPI) is running at 4.2% a year, in effect, your cash is losing value in 'real' terms (that is, after inflation).The obvious answer to this problem is to avoid paying tax on your savings interest -- legally, of course! Let's start by looking at the most common tax-free savings account in the UK: the mini cash ISA (Individual Savings Account). Don't be fooled by the fancy name, because a mini cash ISA is nothing more than a tax-free savings account with a few strings attached.Because of its attractive tax-free status, there is a yearly limit on how much you can pay into a cash ISA, which is £3,000 per tax year (tax years run from 6 April one year to 5 April the next). Also, if you want to switch existing cash ISAs to a provider which pays a higher rate of interest, you can do this. However, the transfer must be organised by the banks themselves; you cannot simply withdraw the cash from one ISA and use it to fund another, as you lose that year's allowance.By the way, for more information on TESSAs (Tax-Exempt Special Savings Accounts) and TOISAs (TESSA-only ISAs), the forerunners of cash ISAs, read Switch To A Great Savings Rate.To date, mini cash ISAs have been around eight tax years (since the 1999/2000 tax year), so a keen saver could have amassed £24,000 in these super savings accounts, plus a tidy sum in accrued interest. Thus, a careful couple might have £50,000 or more stashed away in cash ISAs, earning upwards of £2,500 a year in tax-free interest. What's more, this income doesn't have to be declared on tax returns, which is another plus.That's all well and good, but what about if you have more than £3,000 a year to save and don't want to put your money at risk by investing in shares and other volatile investments? In other words, are there any other tax-free deposit accounts in which your money is entirely safe?Happily, sensible savers can turn to the government's own bank: National Savings & Investments (NS&I). As NS&I is backed by the 'full faith and credit' of the British government, it's about the safest savings institution there is -- in effect, 100% secure. At present, 27 million people have entrusted over £78 billion to NS&I, making it one of the UK's leading savings providers.NS&I offers a range of tax-free savings accounts for UK residents, as follows:Fixed Interest Savings Certificates (maximum deposit: £30,000 in total)These are tax-free savings bonds which require a minimum deposit of £100 and a maximum of £15,000 per issue. The two latest issues are the two-year 35th issue, which pays a fixed, tax-free compound interest rate of 3.65% a year, and the five-year 84th issue, which pays 3.50% a year.Index-linked Savings Certificates (maximum deposit: £30,000 in total)These are guaranteed to match the RPI rate of inflation (currently 4.2% a year), with a fixed rate of interest on top. The minimum deposit per issue is £100 and the maximum is £15,000. The three-year 14th issue pays a tax-free compound rate of 1.15% a year on top of the RPI (which comes to 5.35% at present), and the five-year 41st issue pays RPI plus 1.1% (5.3% a year).Premium Bonds (maximum: £30,000)Rather than paying interest, buying Premium Bonds entitles you to enter a monthly prize draw. Each £1 invested gives you the chance of winning a number of tax-free prizes, ranging from £50 to £1 million jackpots. Naturally, your invididual return will depend on your luck, but the current prize-fund rate is 3.60% a year, and the latest odds of a £1 bond winning any of almost 1½ million monthly prizes are 24,000 to 1.Children's Bonus Bonds (maximum: £3,000)These are fixed-rate, five-year investments which are tax free for a child and its parents, grandparents, other relatives or friends. Issue 22 pays a tax-free compound rate of 4.60% a year, and you can save up to £3,000 per issue per child in Children's Bonus Bonds.Thus, if you have a spare £93,000, you can entrust the lot to NS&I and enjoy tax-free, risk-free returns. For me personally, this approach would require too much caution and patience, so I prefer to invest my spare cash in the stock market. Hence, in a later article, I'll review the tax shelters for stock-market investments.Summary of NS&I's tax-free savings accountsAccount/Maximum depositTax-free interest rate (% a year)Fixed Interest Savings Certificates£30,000 in totalTwo-year: 3.55Five-year: 3.50Index-linked Savings Certificates£30,000 in totalThree-year: 5.35Five-year: 5.30(assuming RPI remains at 4.2% a year)Premium Bonds£30,000 in total3.60(with average luck)Children's Bonus Bonds£3,000 in total4.60More: Check out these everyday savings accounts, tax-free investments and children's accounts