Since the introduction of the personal savings allowance (PSA) in 2016, some people have questioned the value of cash ISAs.
Is it worth having an ISA when you may be able to earn interest tax-free with a PSA?
Even with PSAs, ISAs are still a good option for many people. There are several benefits to ISAs, including for long-term savings, inheritance, and reducing risk.
We outline the personal savings allowance and why ISAs are still an attractive option below.
If you’re looking for more information on ISAs and the types of ISAs available, visit our ISAs explained guide.
The personal savings allowance enables most people to earn interest tax-free across various savings options. It is in addition to the ISA allowance. Any interest earned on an ISA is not part of your PSA.
The allowance applies to interest earned in bank accounts, savings accounts, credit union accounts, building societies, corporate bonds, government bonds, gilts, peer-to-peer lending, and interest distributions (but not dividend distributions) from authorised unit trusts, open-ended investment companies and investment trusts, and most types of purchased life annuity payments.
How much you can save tax-free depends on the rate of income tax you pay. Basic-rate taxpayers can earn up to £1,000 in savings interest per year without paying tax, while higher rate taxpayers can earn £500. However, additional rate taxpayers do not get an allowance.
Because of the PSA, less than 5% of people in the UK pay tax on their savings interest.
Some people wonder what the benefit of saving within a tax-free ISA is if they already have a separate tax-free personal savings allowance.
But despite the PSA, cash ISAs can still be a good option for savers.
The tax-free benefits of an ISA go beyond one year. The current ISA limit allows you to invest up to £20,000 each year. You can continue to earn tax-free savings on this investment for years to come and increase your balance by topping it up every year. If you regularly save the maximum in an ISA, you could soon earn a considerable amount of interest. But thanks to ISAs' tax-free benefit, you won't pay any tax — even if the interest you earn exceeds the PSA limit.
Plus, even when ISA rates are low, you’re still more likely to get a better interest rate in a fixed rate ISA account than a normal savings account. So, if you are able to lock your money away, you could get a higher return with a fixed term ISA than some of the account types covered by the PSA.
ISAs can be more tax-efficient than other savings accounts when it comes to inheritance.
Married couples or those in civil partnerships can inherit their partner’s ISA allowance. This means the surviving partner can save a larger amount in an ISA without paying tax.
For example, if a person had £60,000 worth of ISA assets, their widow(er)'s ISA allowance would increase by £60,000. This even applies if the surviving spouse is not inheriting the ISA assets. So, if the deceased partner had left their ISA funds to their child, the partner would still be entitled to increase their ISA allowance by the same amount. However, they would need to fund it separately by paying the equivalent sum into an ISA in their sole name.
The bereaved spouse can claim an increased ISA allowance up to three years after the date of the death of their partner, or if longer, 180 days after the estate has been administered.
If interest rates rise, you could exceed your PSA and become liable for tax.
Saving your money in an ISA will mean you can be sure that you will not be charged tax (providing that you do not exceed your annual investment allowance of £20,000).
Investing in an ISA guarantees that any interest will remain tax-free no matter how high the interest rates rise.
These are just some of the reasons why ISAs can be an attractive savings choice. For more information on what to consider before investing in an ISA, visit our list of the pros and cons of cash ISAs.
ISAs are just one of the types of savings accounts available.