You could earn 5.8% on your savings (with a catch)

This new account could help you earn a great tax-free return and beat inflation.

The recent withdrawal of National Savings & Investments (NS&I) Index-Linked Savings Certificates came as a huge blow for savers up and down the country. Not only did the popular certificates allow you to beat inflation, they also offered a return which was totally tax-free, without using up your ISA allowance. What’s more, savers could enjoy the security that comes with HM Treasury backing.

Clearly, the index-linked accounts were one of the very few shining beacons left in an otherwise dismal savings market. There really hasn’t been much to celebrate recently with interest rates hitting all-time lows. Worse still, inflation remains way beyond the government’s 2% target. In fact, many savings accounts have actually been delivering negative returns with inflation eating into the real value of cash.

Saving the day

But there has been some respite in the form of the latest issue of the Index-Linked Cash ISA from National Counties Building Society which has just been re-launched onto the market. The good news is the account is very similar to the NS&I inflation-busting certificates that were withdrawn, offering a return that promises to pay the rate of inflation - as measured by the Retail Prices Index (RPI) - plus an extra 1% fixed. And, because the account is held within an ISA wrapper, it’s completely tax-free too.

The last RPI figures showed inflation at 4.8%. If inflation remains this high, this account will pay a rate of 5.8% tax-free. I don’t need to tell you this rate would be a market-leading return in the current savings climate.

But note the 'if'. That rate is by no means guaranteed. After all, no one knows for sure what the rate of inflation will be in the future. We do, however, know what it was in the past.

Will you really earn a decent rate?

The account has a fixed term of five years. Looking back five years, National Counties say that the annual rate of return based on the change in the RPI between July 2005 and July 2010 would have provided a yearly return of 3.96% AER.  

But how likely is it that you will to continue earn competitive rates in the future? After all, this is only an illustrative return and past performance is no guide to the future. Inflation may be high now, but how long will it stay that way? The Monetary Policy Committee is tasked with reigning inflation in to 2%. If they succeed, the returns paid from the National Counties ISA could be considerably lower.  

On the other side of the coin, the rise in VAT from 17.5% to 20% planned for January 2010 looks set to stoke inflation again, alongside rising food and fuel prices. But this may only be responsible for an increase in the RPI over the short-term.

At the very least, what you do know for certain is that your cash will always provide a real return by beating the inflation rate by 1% (tax-free). This is a good deal more than can be said for many other savings accounts.

But bear in mind if there’s no change in the RPI over the five-year term, or it falls and deflation sets in (which could be a longer-term risk) you’ll earn a tax-free fixed rate of 1% only.

Key features of the National Counties Index Linked Cash ISA

Assuming you’re prepared to take a gamble on inflation staying high, let’s take a look at everything the account has to offer in more detail.

First of all, the Index Linked Cash ISA is limited issue which means it’s only available to savers for a set period. At the moment deposits have to be made by 30 September, but the account could be withdrawn from the shelves sooner if it becomes over-subscribed. This is a distinct possibility given that inflation-beating accounts are usually pretty attractive, particularly when the RPI is high.

You must save a minimum lump sum of £5,100 which equates to your full cash ISA allowance for this tax year. You can, however, save more by transferring ISA money from previous tax years over to the National Counties account, up to a maximum of £50,000.

The ISA matures on 1 October 2015. Until this date your cash will be completely locked away and you won’t be able to make any withdrawals. If you wish, you can transfer your ISA to an alternative provider during the fixed term, but you’ll forfeit your index-linked return.

Is National Counties a good replacement for NS&I?

There are the key differences between the two types of accounts which you should be aware of. Firstly, the National Counties account will use up all your cash ISA allowance, whereas NS&I provided additional tax-free returns.

Secondly, the contributions limits to the National Counties ISA are much more restrictive allowing you to save a lump sum of £5,100 only this year - no more, no less (unless you transfer an old cash ISA). Savers with NS&I, on the other hand, could save between £100 and £15,000 per certificate and had a choice of a three-year or five-year term.

Other than that, the two accounts share many similarities, and the National Counties ISA is likely to prove popular with savers who were miffed at the disappearance of the NS&I certificates.

A better alternative?

Finally, the Index Linked Cash ISA may guarantee to beat inflation, but the actual return you’ll receive remains an unknown quantity. If you’re not convinced inflation will stay high throughout the five-year term, a fixed rate ISA may be a better choice.

The Halifax Fixed Rate ISA Saver, for example, pays a rate of 4.25% fixed for the next four years, and only requires a minimum investment of £500.  Meanwhile, the Birmingham Midshires 5 Year Fixed Rate Saver pays the same rate over a slightly longer five-year term.

Compare savings accounts and cash ISAs at lovemoney.com

More: Win more cash from Premium Bonds | Six top savings accounts out now