Stop inflation destroying your savings

The cost of living is at a 14-month high with new figures released today showing that the consumer index of inflation has hit 3.5%. We show you how to prepare your finances against the coming storm.

You didn't imagine it - the cost of living really is rising significantly. New figures show that the UK level of inflation hit 3.5% in January - up from December's level of 2.9%. The 0.6% climb is the second-highest monthly increase for the Consumer Prices Index level of inflation since records began in 1996 and pushes inflation to its highest level since November 2008.

Two main factors have fuelled the surge in living costs. The return of rising petrol prices pushed up costs, while the end of the emergency VAT cut on January 1 saw the government levy on everyday items return to 17.5%.

 Today's report also shows that figures the headline rate of Retail Prices Index (RPI) inflation - which includes mortgage interest payments - also rocketed in January, to 3.7% from 2.4%.

The gloomy figures will force Bank of England Governor Mervyn King to write a letter to the Government explaining why inflation is so far above the Bank's 2% target. He has predicted that inflation will fall to 1.8% towards the end of 2010 as the effect of January's one-off items eases - but it doesn't do any harm to prepare your finances for the worst.

Get saving   

It's always wise to build a rainy-day fund - and particularly prudent today. Among the emergency measures to tackle the ballooning deficit being considered by all three parties as the General Election nears is a hike in VAT to 20% - which will make us all feel poorer. What's more, interest rates can't stay at 0.5% forever.

• Adopt our step-by-step goal to help you build up your savings.

With interest rates at a record low, the savings outlook has been grim - and it's become worse as banks have trimmed savings rates to subsidise cuts on mortgage deals.

Following today's announcement, a basic rate tax-payer would have to find an easy access savings account paying at least 4.38% to stop their savings pot eroding away in real terms. Yet the top easy access savings accounts paying little more than 3%.

Tax-free cash savings

Your first move should be to make full use of your tax-free ISA savings allowance - you can currently save up to £3,600 (£5,100 for those over 50) in this tax year without paying anything to HMRC. From April, the limit rises to £5,100 for everyone - which means you don't have to pay 20% savings tax on that sum.

You can also transfer existing savings within a tax year on certain accounts to benefit from the best rate. Be aware, however, that you lose the tax-free status on your Isa if you withdraw the money from your existing provider yourself and transfer it to your new provider.

If you can afford to keep your money locked away, you can find a tax-free return of 3%. The Newcastle Building Society is currently offering a tax-free return of 3% in exchange for a 120-day notice period. Be aware that the rate includes a 1% bonus for 12 months - make a withdrawal before and the rate falls to a less-attractive 2%.

One of the best 'no-strings' cash Isas on the market is the Santander Direct ISA which pays 2.75% interest with no bonus rates. Be aware that the full 2.75% interest is only paid on balances above £9,000 - below that the accounts pays out 2%. That's still 1.5% above base rate.

An alternative option is the Alliance & Leicester Direct ISA - the Santander-owned bank's product is similar but it comes with a higher bonus rate. Both products offer instant access to your cash with no penalties.

For longer-term investing, you may want to consider ISA products that invest in the stock market - find out more with our guide.

Index-linked savings

Another way to beat the ravages of inflation is to find an account that pays a guaranteed return above inflation with no savings tax. Understandably, these are pretty scarce and demand for them is high. The main provider is the Government's National Savings and Investments (NS&I).  

You can opt for a three or five-year term and the current range - Issue 19 of the three-year certificate and Issue 46 of the five-year certificate - pays 1.00% above the RPI index level of inflation - that works out at a return of 4.7%.

Two final smart tricks

Another way to shelter your savings from the taxman is to combine them with your mortgage in an offset mortgage. These accounts use your mortgage as a huge overdraft and your savings are offset against it. The interest that you would have acquired on your savings is set as the same interest rate on your mortgage - which means you get tax-free interest paid on your headline mortgage rate.

Be warned that these mortgages require immense financial discipline - live the high life, and you'll soon erode the capital paid-off. Find out more with our guide to offset mortgages. 

Finally, in this environment it's also worth finding a current account that pays interest on in-credit balances - for example, the Alliance & Leicester Premier Direct account pays 6% interest on balances up to £2,500 from one year of opening. That's a rate that shames the current rates available on easy access savings accounts.

If you need a little help to get into the savings habit, why not adopt one of our goals such as Build Up Your Savings? Or head to our Q&A section if you've got a particular query.

Compare savings accounts at lovemoney.com