ISAs vs savings accounts: which is better for your money?

If you are looking to build a savings pot, then working out precisely where to save your money is an important decision ‒ here we put ISAs vs savings accounts in a head-to-head.

There is no shortage of the best savings accounts to choose from, but a big factor to consider is whether to focus your attention on regular savings accounts or the best cash ISAs. 

Both have their own merits, and determining the sort of account you want to open can help you make the best selection for your long-term financial health.

So how do you choose between traditional savings accounts and ISAs? Here we run through the pros and cons of each to help you make a more informed choice.

ISAs vs savings accounts

The pros of traditional savings accounts

Placing your cash within a traditional savings account has become more attractive from a taxation perspective in recent years. 

That’s on account of the personal savings allowance, which was introduced back in 2016. The allowance means that most taxpayers can earn a certain amount in interest from their savings accounts before having to pay any tax on those returns. The thresholds for the savings allowance stand at £1,000 per year for basic rate taxpayers and £500 for higher rate taxpayers. Additional rate taxpayers don’t get a personal savings allowance.

With the interest rates on regular savings accounts having been so low in recent years, it’s been harder for savers to hit that limit, meaning that many savers have enjoyed tax-free returns from their savings.

In addition, the interest rates paid on regular savings accounts tend to be somewhat higher than those paid on ISAs. For example, at the time of writing, the highest rate on offer for a regular easy-access account is 5%, compared with 2.50% on an easy-access ISA. Similarly, on a one-year fixed rate, you can get 4.61% from a regular savings deal, but only 3.95% from a one-year fixed rate ISA.

While there are sometimes limits on how much can be saved within a typical savings account, it is rare and usually, there’s no cap ‒ you can stick as much money as you like in there.

The cons of traditional savings accounts

The big negative of saving with a regular savings account is the tax situation.

If you start earning above the personal savings allowance, then you will have to pay tax on the returns from the money you are saving.

But, this really only affects you if you have set aside a significant amount. Basic rate taxpayers will start paying tax on their savings returns once they have £42,500, while higher rate taxpayers will pay once they have £21,250 if they stick it in a savings account that pays 2.35%, according to research by AJ Bell.

Moving to a two-year fixed rate paying 4.5% would see those thresholds drop to £22,200 and £11,100 respectively.

Should interest rates on savings deals increase ‒ widely expected ‒ then it will push more savers to pay tax on the returns from their savings deals.

The pros of cash ISAs

The big selling point for an ISA is how much you can save each year within one, without having to pay tax on the returns. It’s currently set at £20,000 for the current financial year.

Each tax year you get a new allowance, on top of what you’ve already saved. So if I’ve saved £5,000 in the 2022/23 tax year, from April 2023 I’ll get another £20,000 that I can put into my ISA on top of that. 

There is also a range of different types of ISA which can come in useful for different types of savers, based on what they are hoping to do with the money they are setting aside.

For example, if you want to keep your money in cash then you can opt for a Cash ISA, while a Stocks and Shares ISA offers the opportunity to enjoy tax-free returns from putting your money into the stock market. 

Alternatively, there is the Lifetime ISA, which is designed to help savers either build a house deposit or save for retirement and comes with an annual bonus from the government of 25% of the amount saved, with that bonus capped at £1,000.

There is also the Innovative Finance ISA, for those looking to invest in alternative assets and Junior ISAs for parents wanting to set money aside for their children.

While the personal savings allowance is currently more than enough for many savers, if rates continue to increase those with more savings will risk paying tax on their returns. 

This is when an ISA comes in useful ‒ with an ISA, you can avoid paying tax on any of the returns generated.

The cons of cash ISAs

There are some important downsides to Cash ISAs.

While that annual limit will be more than enough for most of us, there will inevitably be some people who'd like to save more but can't. It’s also important to bear in mind that this annual limit cannot be carried over ‒ if you don’t use it, then you lose it.

Also, you are only allowed to open one new ISA of each type each year. You can still contribute to older ones, however. So I could open a new Lifetime ISA this year, along with my existing Cash ISA and contribute to both. But I couldn’t open two separate Stocks and Shares ISAs in this tax year.

What’s more, moving money between ISAs can also be more complex than with a normal savings deal. Not all ISAs accept transfers, for example, meaning you can only open one with ‘new’ money, rather than an existing ISA balance. 

In addition, if you are moving money from one ISA to another, it will have to happen directly, otherwise, it will lose its tax-free status ‒ you can’t move it from an ISA into a regular easy access deal and then on to a new ISA.

Interest rates on Cash ISAs are often lower than those paid on regular savings accounts ‒ not always, but often. Depending on the size of your savings balance, this may mean that you are worse off, at least in the short term.

The verdict ‒ take the mix and match approach

If you pay savings tax or you think you will do so soon ‒ maxing out your ISA limit is worth it.

Beyond that working out whether a typical savings account or an ISA will come down to you as an individual and your own needs. But, it’s worth bearing in mind that it doesn’t have to be an either/or approach ‒ you can use both types of accounts.

For example, you might want to keep money that you’re saving for the long term in a Stocks and Shares ISA, but keep some emergency cash in a typical easy-access savings account which you can turn to should the need arise.

Similarly, if you are lucky enough to be able to put £20,000 aside into an ISA, that doesn’t have to be the limit of your saving ‒ you can also put some more cash into a regular savings account too.

That said, ISAs are only likely to become more attractive as interest rates rise, and increasing numbers of savers face the potential of having to pay tax on the returns they enjoy.

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