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Cash ISAs are one of the easiest and most tax efficient ways to save

With interest rates at record lows, it's hard to earn a decent return on your money. Not only do cash ISAs normally offer a higher rate of interest than most standard bank accounts, but they also offer a valuable tax break.

In 1999, the UK Government launched ISAs (Individual Savings Accounts) to encourage UK residents to save. They replaced the old Personal Equity Plans (PEPs) and Tax-Exempt Special Savings Accounts (TESSAs), both of which were more complex financial products. Many people think that ISAs are as complicated and are still wary of them. But they couldn't be further from the truth: a cash ISA is basically a savings account.

The main difference to a normal savings account is also the main benefit of a cash ISA. If you save through an ISA, you're not liable to pay any UK Income Tax on the interest earned. For this reason alone, cash ISAs should normally be the first port of call for savers, but evidence shows that many UK residents fail to take advantage of the tax benefits offered by them. This means that most savers end up paying more tax than they need to.

How your ISA allowance works

For the 2014/15 tax year, you're entitled to contribute up to £15,000 into an ISA. This can be saved in a cash ISA with one provider, a stocks and shares ISA with the same or different provider, or any combination of the two. You can put money into a cash ISA at any time during the tax year. Once you've contributed your full allowance, if you withdraw all or a portion of it, you can't contribute it again for that tax year. However, you can transfer ISAs from previous tax years to a new provider without affecting your annual subscription allowance.

Please note: cash ISAs can only be opened in sole names as the tax benefits and limits apply to an individual person.

Brief summary

Cash ISAs all have one thing in common: the interest you earn from them is tax free and paid to you gross. However, there are some differences between them:

  • They will offer you different rates of interest
  • Some offer a fixed rate of interest while others offer a variable rate
  • Some allow you instant access to your money, while others may be for a fixed term
  • Some require a minimum investment, ranging from as little as £1 to the full annual subscription allowance.

In order to subscribe to a cash ISA an individual must be aged over 16, be resident in the UK, or a Crown employee serving overseas, or married to, or in a civil partnership with a person, who carries out these duties.

Transfers in

In addition to saving your allowance for the current tax year, you can also transfer in any money saved in cash ISAs and stocks and shares ISAs in previous years. If you are transferring in current year subscriptions, all of these must be transferred. However, not all providers accept transfers in, so this is something to consider when comparing products. Transfers are allowed between cash ISAs, from cash ISAs to stocks and shares ISAs and from stocks and shares ISAs to cash ISAs.

You should check this carefully, because once you withdraw money from an ISA, you lose its tax-free status. If your new provider does allow transfers in, don't withdraw the money yourself. Instead, you should contact your new provider and ask them to arrange the transfer for you.

Tax benefits explained

Financial institutions will usually deduct 20% tax from any interest paid on savings accounts, but if your taxable income is below your personal allowance you may reclaim back any tax paid. Standard rate taxpayers will be unable to reclaim and higher rate and additional rate taxpayers will have more tax to pay. However with cash ISAs this interest is tax free. So if you're a higher-rate taxpayer who pays income tax at 40%, and you deposit £15,000 into a cash ISA paying 3% interest, you'll receive tax savings of £180 a year compared to a normal savings account paying the same rate.

In order to receive the same amount of interest from a normal savings account, you'd need to find one that offers a 5% interest rate to better the interest you'd receive from a cash ISA offering just 3%. That's because you'd have to pay over 40% of your 5% interest earned (which is 2%) to HM Revenue & Customs with a normal savings account.

Choosing a fixed or variable rate

Since 2008, fixed rate ISAs have generally provided higher interest rates than variable-rate ISAs as interest rates have continued to fall. However, this does not necessarily mean that a fixed-rate ISA will offer higher interest rates in the future. With the current Bank of England Base Rate of only 0.5%, savers have to decide whether it is better to fix or not. If the Base Rate is increased, being locked into a fixed-rate ISA may be a disadvantage, depending on the rate secured. However, if ISA rates remain static or fall, then a fixed rate may be an advantage. Often savers feel more secure receiving a fixed rate, because then they are guaranteed a specific interest rate for the period, making it easier for them to budget.

The most important consideration when choosing between a fixed and variable rate, is whether you'll need to access the cash you invest in the ISA. Withdrawing money from a fixed-rate ISA normally costs you around 180 days of interest, possibly cancelling out any tax advantages you've gained. If you're unsure whether you'll need to access your cash in any way, it may make sense to choose a variable-rate ISA where such penalties won't be imposed.

ISA providers

Cash ISAs are offered by most banks, building societies and financial institutions and every ISA they offer has to be administered by an ISA manager. Generally, you should be able to transfer your funds from one provider to another, but some managers may impose a penalty for doing so. In addition, interest rates and other terms and conditions offered by different providers vary greatly, so it's best to do your homework or speak to a professional before you commit to one.

If you'd like to have a look at the range of cash ISAs offered by HSBC, please visit our Savings pages.

Next steps

Everyone's circumstances are different and what applies to one person may not be right for the next. The suggestions above are not intended to provide advice or recommendation on your individual financial needs.

Check if you qualify for advice

If you have £50,000 or more in savings and investments, you may be eligible for HSBC Premier Financial Advice. See the full eligibility criteria.

If you don't qualify for HSBC Premier Financial Advice or if you'd rather not pay for advice, see other ways we can help.

The value of tax benefits will depend on your individual circumstances and tax rules may change in the future.

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