Cash ISAs explained

A cash ISA is a tax-efficient savings account that allows you to deposit money without paying tax on the interest you receive. In this part of our ISA guide we explain how cash ISAs work in more detail.

The key facts about cash ISAs

To open a cash ISA you must be a UK resident (or a Crown employee serving overseas, or the spouse of such an employee); and be aged 16 or over. When you open a cash ISA you’ll be required to provide a form of ID, such as a passport or driving licence, along with your National Insurance number. You can only open a cash ISA with one provider each tax year, although you can have different cash ISAs with different providers in different years. Essentially this means that you can’t split your annual allowance between different providers.

The cash ISA allowance for the current year (2012/2013) is £5,640.

With an easy access cash ISA you can withdraw money without giving notice and without penalty; other types of cash ISA (e.g. fixed rate ISAs) may be more restrictive. When you withdraw money from a cash ISA you cannot re-invest it at a later date with the intention of topping the balance up. This is because you can only invest up to the ISA allowance for that tax year, regardless of how many withdrawals you make.

Is a cash ISA better than a savings account?

The crucial difference between a cash ISA and a savings account is that with a cash ISA you do not pay tax on the interest you earn. With a savings account, the interest you earn will be subject to tax at a rate determined by your current rate of income tax; this will be deducted automatically when the interest is paid to you unless you have an offshore account (in which case you will need to declare it on your annual tax return).

The table below illustrates the rates of tax on savings interest.

As you can only invest a limited amount of money in a cash ISA each year, you may also choose to open a savings account for any surplus funds.

Remember!  Whether you opt for a savings account, an ISA or both, you should always shop around and compare products and providers in order to find the best deal.

What do you need to be aware of when choosing a cash ISA?

When you compare cash ISAs there are terms and conditions that it pays to be aware of, including:

If you think you may need access to your money during the tax year then watch out for limits placed on the number or frequency of withdrawals, or withdrawal penalties that may affect the amount of interest you receive.

Bonus rates are a popular way for ISA providers to attract new customers however these are usually short term and once the bonus period ends the interest rate may not be competitive. While it’s worth taking advantage of bonus rates for the first year, to maximise your returns you should switch to another account when the bonus period ends.

With the majority of easy access cash ISAs you’ll be able to deposit money as often as you wish providing you don’t exceed your annual allowance. However some accounts (e.g. fixed rate or notice ISAs) will be more restrictive and may permit a single deposit only, may limit the number of deposits you can make or may require that any deposits are of a minimum value.

With some accounts the minimum balance permitted may be as low as £1 but other accounts will have higher minimum balance requirements. This is one to watch out for if you do plan on making any withdrawals.

By transferring your cash to another product you can take advantage of more competitive interest rates however some providers do not permit transfers or may penalise you for making the switch to another provider.

How do I switch a cash ISA?

By switching your cash ISA you can take advantage of more competitive interest rates and get better value for money, particularly since some cash ISAs have bonus rates that end after the first year and then revert to a less attractive standard rate.

Switching a cash ISA is a relatively simple process, however if you do plan on switching then it’s crucial that you do not make any withdrawals, even if you simply intend to move the money elsewhere. This is because any money that is withdrawn loses its tax-free status.

Rather than closing one ISA and opening another you should request a transfer; your new ISA provider can arrange this for you. You’ll simply need to complete a transfer form and the money will be moved without losing its tax-free status.

When you transfer a cash ISA remember that:

• The current year’s ISA balance must be transferred whole and cannot be split between providers.
• Any previous years’ ISA balances can be split between different providers.
• If your provider enforces a transfer penalty then switching may not be worthwhile as the penalty could outweigh the gains you’d make from switching to a more competitive interest rate.
• It usually makes good sense to wait until the annual interest payment has been made by your current provider.

Cash ISAs: our five top tips

• Shop around for the best deal; once you've opened your ISA check that it remains competitive.
• To maximise your tax-efficient savings, invest the full annual allowance if possible.
• The earlier in the tax year that you invest, the more interest you can earn.
• Avoid withdrawals as the money can't be re-invested during the same tax year.
• To maintain your money's tax-free status when you switch ISAs, arrange a transfer rather than closing one account and opening another.

In the next part of our guide we look at stocks and shares ISAs in more detail.

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