Is a cash isa worth it?

If you have been able to put aside a little money during the pandemic, the question is what to do with it. With banks paying a pittance in interest at the moment, the pickings are slim. Is a cash isa worth it?  

What is a cash isa? 

A cash isa (individual savings account) is very similar to an ordinary savings account except for one key difference: it comes, as do all isas, with a tax perk.

An isa is like a safety deposit box: everything you put inside, including any growth, is free from the grabbing hands of the taxman. Currently you can squirrel away up to £20,000 each tax year and you won’t pay a penny on any interest earned while your money is inside the isa.

With rates so low at the moment that might not seem a big deal now but it can make a difference over time. 

If you don’t use your £20,000 annual allowance, you cannot carry what’s left into the following tax year. The isa clock starts again at 00:00 on April 6. 

While you can hold multiple cash isas at any one time from different providers, you are only allowed to open and pay into one cash isa each tax year. Note that transfers from previous year’s isas into your new account don’t count towards your annual limit. 

Finally, you can’t hold an isa on behalf of anyone else - hence the ‘individual’ part. 

How much can I save? 

Everyone can - in theory, at least - save up to £20,000 into their cash isa every tax year (Apr 6 -Apr 5 following year).

However, you might have heard of other types of isa:

•  Stocks & shares isa - your money is invested in the stock market 
•  Lifetime Isa - to be spent on the deposit for a house or retirement 
•  Junior Isa - for your kids 
•  Innovative Finance Isas - peer-to-peer lending 

You can open one or a combination of the above, including a cash isa (except the junior isa - that’s for your kids), within a tax year. You cannot open more than one type of isa, however.

For example:

•  Cash isa and stocks & shares isa - YES 
•  Two cash isas - NO 

Your £20,000 allowance can be shared across your accounts in whichever way you choose, as long as you don’t pay in more than this amount in total. Note that the lifetime isa has a lower annual limit of £4000 per tax year, leaving you with £16,000 to put into your other accounts. 

Types of cash isa

We’ve discussed the different types of isa, but there are also different cash isas available. Which you choose depends on your personal circumstances and when you might need access to the money: 

I may need the money immediately: Easy-access cash ISAs allow you to put money inside and take it out when you need it with no penalty to pay

Pro: Perfect for emergency savings

Con: Rates can be pretty paltry

I could wait a little bit: Notice cash ISAs require that you give the bank or building society a certain number of days' notice to withdraw your money, typically between 30 and 90 days

Pro: Rates are often better than easy access

Con: 90 days, for example, can feel a long time when you need the money

I don’t need the money for a while: Fixed rate cash ISAs require that you lock your money away for a longer period of time, typically between 1 and 5 years, and in return you will get a fixed rate of interest.

Pro: Tend to offer the best rates; good if interest rates on savings accounts go down

Con: You face a penalty if you withdraw your money before the end of the fixed term; bad if interest rates go up

The Help to Buy isa is also a cash isa but it has now been closed to new applicants. These were aimed at helping first-time buyers get on the property ladder and have been replaced by the Lifetime Isa, which also comes with a generous government bonus.

(MORE: Savings and tax: what you need to know)

Who can open one? 

Opening a cash isa is straight-forward and free. They are available from most banks and building societies, including online banks, as well as the Post office. You might find that the smaller banks offer the best rates, so it’s important to shop around.

Not everyone can open a cash isa. In order to do so, you must be:

•  Aged 16 or over 
•  A UK resident 

 Pros and cons of opening a cash isa 

There are a number of things to consider if you are looking at opening a cash isa as a number of changes recently have left people wondering if they are worth it.

Pros

•  A great way to build up your essential 3-6 months emergency savings pot 
•  Simple to understand, straight-forward and free to set up 
•  No tax payable on any interest earned while your money is inside the isa - ever 
•  Generous £20,000 allowance 
•  Your isa savings can be inherited by your spouse without impacting their allowance for that tax year 

Cons

•  All basic rate taxpayers can earn £1,000 of savings interest a year tax-free anyway, under the Personal Savings Allowance (£500 a year if you are a higher rate taxpayer) 
•  If the rate on your cash isa is lower than the rate of inflation, the money in your pot is effectively being eroded 
•  Cash tends to deliver lower returns than if you were invested in the stock market which carries more risk 
•  While there is no tax to pay on the way out, there is no tax relief on ISA contributions on the way in as you would get with pension contributions in a SIPP 

Why would you pick a cash isa over a stocks and shares isa? 

Spoiler alert: you can pick both.

An easy access cash isa is an excellent home for your emergency savings pot. This is three to six months of outgoings saved up in case something goes wrong, such as the car breaks down or you crack your tooth. It is also great for giving you peace of mind, knowing that you have a financial buffer in place.

That doesn’t mean you should leave your money languishing there for when the time comes to use it. You can easily transfer your isa pot between providers, so there is no excuse not to shop around to make sure you are getting the best possible rate for your money. 

If you have managed to save up more than six months outgoings, and are happy tying your money up for at least five years, it might be worth looking at investing. While putting your money in the stock market carries risk, it is important to remember that a cash isa is not completely risk free either. If the interest rate of your account is lower than the rate of inflation, the value of your pot is effectively being eroded by the rising cost of living, meaning your money won’t stretch as far in the future. If you are new to investing, a ready-made stocks and shares isa is a great way to get started.