Sammie Ellard-King
I’m Sammie, a money expert and business owner passionate about helping you take control of your wallet. My mission with Up the Gains is to create a safe space to help improve your finances, cut your costs and make you feel good while doing it.
Are you thinking about opening an ISA and are wondering about Cash ISAs?
It can be a minefield to choose the best ISA so we understand you looking around for the right one.
Knowing what you want from your finances and accounts is essential as it can help you pinpoint the right ISA for you.Â
But how does a cash ISA work? This post will tell you all you need to know.
Table of Contents
How does a Cash ISA work?
A cash ISA is a tax-free way of saving money. You’ll earn a set amount of interest on the amount of money you put away.
If you choose an easy-access account it will be a lower amount than if you decided to lock your money away for a fixed period of time.
This could be 1, 2 or maybe 3 years. There is a benefit to easy access should you need to get your hands on the money, penalty-free.
If you choose to put money away for a longer period to get that higher rate, you can still access it. However, you’ll be hit with a penalty. This could be 90 days of interest or more.
The cash ISA rules state that you must be 16 years of age or older to open a cash ISA, whilst being a resident of the United Kingdom.
How much can I pay into my Cash ISA?
When you have opened a cash ISA, you need to know how much you can pay into it.
Your ISA contributions allowance for any financial year is £20k. This can be used all on one product or split across different ISAs.Â
You can have more than one cash ISA, however, you can only pay into one of them every year.Â
You get the £20,000 allowance to use as you see fit. If you decided to withdraw £2000 after using your full allowance that year, you couldn’t deposit that £2k again until the new tax year.Â
It doesn’t deduct from your allowance, so you lose the tax-free benefit on that money. It’s worth remembering that nothing gets carried over when your allowance resets, so it’s a use-it-or-lose-it situation.Â
You should also remember that the FSCS protection limit is £85,000 per authorised firm.Â
This means if you have more than £85k with one provider, it could be at risk should something happen to the company.Â
Just because different providers have different names doesn’t mean anything, as some are part of the same firm. You need to check that your money is safe and rest easy with that FSCS protection.
What are the benefits of a Cash ISA
A cash ISA is great if you want the assurance of growth. It might not be huge growth, but growth nonetheless. You’re looking at somewhere between 2% and just over 4%, depending on the account and provider.Â
A £20,000 cash ISA at 4%, will be £24,333 after 5 years and that’s without adding any more to it yourself.Â
Yes, you might be able to get a higher return by using something like a stocks and shares ISA, but there is no guaranteed growth in that, as stocks and shares can go down in value as well as up.Â
Albeit over a long period of time on average you can make higher returns with a Stocks and Shares ISA. We discuss this more in our post Cash ISAs vs Stocks and Shares ISAs.
The average return on S&S ISAs in 2020/21 was 13.55%. However, the year before it was -13.33%. It can be risky.Â
There is no risk with a cash ISA, so you know your money is secure and you can enjoy growth over time.Â
Pros & Cons Cash ISA
Pros
Tax Efficiency: The interest earned on a Cash ISA is free from income tax, allowing your savings to grow more quickly than in a standard savings account where tax would be due on the interest if you’re a higher or additional rate taxpayer.
Flexibility: Some Cash ISAs offer easy access to your money, meaning you can withdraw funds without losing the tax benefits, although this can vary depending on the specific ISA product.
Simplicity: They are straightforward to set up and manage, with a process similar to any regular savings account.
Allowance Stacking: You get an ISA allowance each tax year, and you can add to your ISA annually, increasing your tax-free savings pot over time.
Transferability: You can transfer your ISA from one provider to another to take advantage of better interest rates without affecting your ISA allowance.
Cons of a Cash ISA
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Lower Interest Rates: Cash ISAs sometimes offer lower interest rates compared to regular savings accounts or other investment options like stocks and shares ISAs.
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Inflation Risk: If the interest rate is lower than the rate of inflation, your savings could lose real-world value over time, even though the balance might be growing.
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Annual Limit: There’s a limit to how much you can put into an ISA each tax year, which means you can’t necessarily shelter all your savings from tax if you have a significant amount to save.
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Fixed Terms: Some Cash ISAs that offer higher interest rates may require you to lock your money away for a set term, reducing accessibility.
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Opportunity Cost: By choosing a Cash ISA over other types of ISAs (like stocks and shares ISAs), you might miss out on potentially higher returns from investments.
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Interest Rates Variability: The interest rates for Cash ISAs can vary with the market, and if they drop, your returns could be less than expected unless you have a fixed-rate ISA.`
Other considerations
You need to ensure that you keep an eye on the interest rate you are getting on the money in your ISA.Â
Sometimes, providers will offer a higher rate for the first year or so, to pull you in, and then that rate drops down.Â
By then, if you are not keeping an eye on your investments, you might forget about the account and have a period of time when your money is making very little.Â
If you find yourself in a situation like this you are able to transfer your ISA to another provider with a higher interest rate.Â
It’s important to follow the transfer process properly because if you simply withdraw the cash and deposit it into a new account, you’re eating into your allowance for that year. A transfer doesn’t impact your ISA allowance.Â
It’s also worth seeing if you can get a higher interest rate in a current account. Most of us can earn £1000 in interest every year, without paying tax. This is the personal savings allowance.Â
It will likely be more work than a simple one-off cash ISA account, however, you can earn more. You might need to open multiple accounts and split your cash into different current accounts.Â
One bank might give you 5% on up to £5k whilst another offers 4% on the first £2000 and 2.5% on anything above that.Â
By moving your money to the best possible places, you can take advantage of these higher interest rates.Â
You might also be able to get a transfer incentive or £200 if you switch your current account to a new provider. An extra bonus!
Are Cash ISAs worth it?
The main benefit of your cash ISA is tax-free growth. When you sign up, you know what rate you will get on your money.Â
Of course, you might get a letter in the post further down the line telling you this is reducing. But you are in control of your money.Â
You can transfer to another provider if you are unhappy and find the best possible place for your finances, tax-free! Using your annual allowance, you can grow your money year after year and take advantage of compound interest.Â
If you were able to deposit the full £20k allowance for 20 years at 5%, your cash ISA could be worth £590,256. That’s a huge £190k earned in interest!
Conclusion
So, how does a cash ISA work? Fairly easily actually! You just have to start saving money.
The sooner you start saving into a cash ISA, the sooner you can start earning that interest and seeing that annual growth.
Put your bonus in, your side hustle money. Put it to work and see the benefits of the interest you receive.
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Disclaimer: Content on this page is for informational purposes and does not constitute financial advice. Always do your own research before making a financially related decision.
