Are ISAs really worth it?

When the government launched the personal savings allowance in 2016, ISAs dropped by 1.6 million. The personal savings allowance lets you earn up to £1,000 tax-free interest a year on any type of savings account. So why bother with an ISA when you might get better interest on another account and still not pay tax? Right?

Well, while ISAs may no longer be the only savings accounts that earn tax-free interest, they have other advantages. Here’s why you should consider opening one.

Your personal savings allowance is £1,000 a year only if you’re a basic rate taxpayer, that is if you pay tax at 20%. The personal savings allowance for higher rate taxpayers is £500 a year. And if you’re lucky enough to earn more than £150,000 a year, you don’t get one at all.

According to the Office of National Statistics, the average Brit earned £569 a week, or £27,312 a year in 2018. This puts most of us in the basic rate tax bracket.

That said, this doesn’t mean your financial situation will never improve. You could win a promotion at work. Or land a big client if you’re self-employed. You’ll be glad you saved in an ISA if this happens, because it’ll keep your savings interest tax-free regardless of your income.

While you can only pay a certain amount of money into an ISA each year — the limit is currently £20,000, there’s no limit to how much tax-free interest you can earn.

With interest rates at all-time lows, a £1,000 personal savings allowance seems quite generous. According to Money Saving Expert, the best savings account interest rate on the market (in Feb 2019) is currently 2.62% on a fixed account. This means you’d need to have £38,500 saved up to go over the personal savings allowance.

But interest rates won’t stay this low forever. And, once they go up, there’ll be a greater chance of your savings becoming taxable than you might think.

To put things in perspective, in 2008 you could earn 5.15% on an instant access savings account. This would’ve put you over the personal savings allowance if you had £19,500 saved up — almost half what you’d need saved today.

Even if interest rates don’t rise to 2008 levels (and you don’t have £19,500 to spare), compound interest means you might go over the limit sooner, rather than later.

Let’s say interest rates rise to 3%. You have £2,000 in a savings account. You also set aside £50 a month, that is £600 a year.

In the first year, the bank would calculate interest on £2,600 — £2,000 plus your £50 a month contribution — and you’d earn £78 in interest.

In the second year, you’d have saved £3,200 (your original £2,000 plus £50 month for two years). But, because of compound interest, the bank would also take the £78 interest you earned in year one into account. So they’d calculate interest on £3,278.

To cut a long story short, you’d start earning more than £1,000 in interest in the eighth year.

Interest on ISAs doesn’t count towards your personal savings allowance

This means you can save up to £20,000 a year in an ISA and also earn up to £1,000 a year tax-free interest from another type of savings account.

Saving up for your first step on the property ladder? Or building a nest egg for your retirement? The government has created special ISAs to make this easier.

If you’ve never owned property before, you can save between £1,600 and £12,000 in a Help-to-Buy ISA. Tax-free interest aside, the government will also pay you a 25% bonus, up to a maximum of £3,000.

Lifetime ISAs work in a similar way. You can save up to £4,000 a year for a property deposit or for retirement and earn tax-free interest. The government will credit your account with an extra 25% every time you make a deposit, up to your 50th birthday.

In 2016, the government introduced flexible ISA rules. As a result, you can make withdrawals from your ISA without affecting your annual allowance or your interest’s tax-free status, as long as you put the money back in the same year.

While banks aren’t obliged to follow these rules, many offer the option. More to the point, this flexibility doesn’t just apply to easy access ISAs. You may also be able to withdraw money from fixed-term cash ISAs, help-to-buy ISAs and even stocks and shares ISAs.

But ISAs are also flexible in other ways.

Not happy with your interest rate? You can transfer to another ISA without losing your money’s tax-free status. And, if you’re married or in a civil partnership, you can inherit each other’s ISAs tax-free.

The government reckons that, as a result of the personal savings allowance, 95% of savers don’t pay tax on savings account interest. But this doesn’t mean ISAs aren’t worth considering anymore.

At the end of the day, saving isn’t just about the interest rate. It’s about picking the account that’ll best help you get closer to your financial goals. While a normal savings account may work well in the short-term, an ISA may be a better bet if you:

● Want to let your savings grow long-term without worrying about tax

● Are in the higher rate tax bracket (or expect to be in it in future)

● Want to save for your first property deposit or set money aside for retirement

● Want more flexibility

Want to learn more about ISAs? Read our answers to your biggest ISA questions.