Seems like an odd post title, but it is the best I could come up with, thinking about what I might search for. So what is this post about?
ISA stands for Individual Savings Accounts, and is a government backed tax free savings account for persons in the UK. There are 2 types of ISA’s available, Cash and Stocks and Shares. They both share an investment limit of £20,000 per tax year at time of writing. The key thing here is that you do not pay any tax on earnings (interest).
You can read more about ISAs here: Individual Savings Accounts (ISAs): Overview – GOV.UK
In this post I am going to share a simple method of comparing rates between a Cash ISA and a regular savings account. Why does this matter? The tax. The rate you are earning in a regular savings account is subject to tax, therefore you don’t actually earn that amount so comparing an ISA rate to a regular savings rate is not a true comparison.
Luckily comparing is easy. The TLDR… multiply the ISA rate:
x1.25 if you are a standard rate tax payer
x1.66 if you are a higher rate tax payer
Here is a simple example. If you find an ISA rate of 4% and are a standard rate tax payer, multiply it by x1.25, which equals 5%.
How does this work?
Lets assume you have £2,000 in regular savings earning 5% per year. After a year you will have earned £100 in interest. However as this is taxable earnings, as a basic rate tax payer you will be charged 20% meaning you will only earn £80 after tax. £80 interest on £2,000 is actually 4%.
So why multiply 1.25 as a standard tax payer? Well actually this is just one way to calculate it, and I actually prefer a different way as it makes more sense in terms of the rate of tax you are paying, which could change.
My preferred way to calculate this would be to divide the ISA rate by 1 minus your tax rate. So for a basic tax payer of 20% it would be 1 – 0.20 = 0.80. Using our example above, 4% divided by 0.80 = 5%.
If you were a higher rate tax payer it would be similar. 1 – 0.40 = 0.6, therefore 4% divided by 0.60 = 6.66%
So, there it is…or is it? For comparing rates that is pretty much it except for one important element:
Tax on savings interest: How much tax you pay – GOV.UK
If you earn less than £17,250, you can the difference between your salary and this figure in savings interest tax free, up to a maximum of £5,000.
Furthermore if you are a basic rate tax payer, you can earn £1,000 of interest tax free, and for higher rate earners its £500 tax free.
If any of the above apply for you, you wont pay tax on the interest you earn anyway, so you wont benefit from the ISA being tax free.
In the end you need to be aware of the best options for saving, which can be tricky. The biggest benefit of an ISA is that the money in the ISA earns tax free forever. As always DYOR, but hopefully this post at least highlights some of the things you should think about, and a neat calculation for comparing ISA rates to regular savings rates.