Catherine Pope

Financial Coach & Workshop Facilitator

Should I put my money in an ISA?

Photo of banknotes
Photo courtesy of www.flickr.com/photos/59937401@N07/5856856001

Admittedly, Individual Savings Accounts (ISAs) aren’t very exciting, but they do offer one of the best tax breaks available to anyone looking to build substantial capital. And the terms are surprisingly generous, too. As with every financial product these days, there are some layers of complexity that make it hard to work out whether an ISA is right for you. In this post, I’ll explain how ISAs work and outline the potential benefits of using them to save cash.

What is an ISA?

An ISA is a tax-free wrapper, so it allows you to wrap your savings and protect them from tax. If you have substantial savings, or you’re a higher-rate taxpayer, this provides a significant benefit. You can invest up to £20,000 each year in some ISAs without paying any tax on the interest or income you receive.

There are currently six types of ISA:

  • Cash ISA
  • Stocks & Shares ISA
  • Innovative Finance ISA
  • Lifetime ISA (available only to people aged under 40)
  • Help to Buy ISA (set to end in November 2019)
  • Junior ISA (available only to children under 18)

They all work differently, so I’ll be dedicating separate blog posts to each type. You can save a maximum of £20,000 across Cash, Stocks & Shares, and Innovative Finance ISAs – so you could put £10,000 in cash, and £5,000 each in the other two.1 You can’t contribute to the same type of ISA with multiple providers within the same tax year, though. For example, if you wanted to divide your cash between two banks, you’d need to stop paying into the first by 5th April, then contribute to the other from 6th April. The money in the first bank will continue to grow, but you won’t be able to add to it.

If you build a monster ISA, it might be worth spreading it across different institutions to balance the risk. The Financial Services Compensation Scheme (FSCS) protects cash savings up to £85,000 per institution, and investments in an ISA up to £50,000. Innovative Finance ISAs are not covered by the FSCS.

Is it worth having a Cash ISA?

Among the ISA family, the cash ISA is the least exciting member. It works just like a traditional savings account, but you don’t pay tax on the interest you receive. This isn’t likely to be an advantage unless you have accumulated over £50,000, as basic-rate taxpayers can currently earn £1,000 interest each year before they’re liable for tax.2 But there are other reasons why a cash ISA is sometimes appropriate.

As I mentioned in an earlier post, cash is not a good option for long-term savings. Inflation is likely to eat away your capital, especially in periods marked by low interest rates. A cash ISA can be useful, though, for saving storing large sums of money in the short term, for example:

  • You’ve sold your house and need to stash some of the equity temporarily and safely before buying another property.
  • You’ve inherited some money and are deciding what to do with it.
  • You’re saving for a major expense, such as a loft conversion or a house deposit (If you’re under 40, a Lifetime ISA could be a better option for the deposit; if you’re over 40, a Help to Buy ISA might be appropriate)

You should check the terms and conditions of any cash ISA you’re considering to ensure it’s suitable in terms of accessibility – some will lock away your money for a fixed period to guarantee a higher interest rate. A few providers offer flexible ISAs. This means you can withdraw the money and then replace it later without affecting your maximum contribution.3

Conclusion

A Cash ISA can be right for some people – it all depends on your circumstances and goals. It’s generally not a good idea when you need long-term growth, such as for retirement savings. In that instance, you could be better off with a Stocks & Shares ISA, the subject of my next post. Indeed, putting money in a Cash ISA reduces how much you can invest in a Stocks & Shares ISA, so don’t waste your allowance unnecessarily. If you want to stick with cash for now, take a look at MoneySavingExpert’s top deals and FAQs. Otherwise, stay tuned to meet the other members of the ISA family.

  1. There are lower limits for Lifetime, Help to Buy, and Junior ISAs. [↩]
  2. The threshold for higher-rate taxpayers is £500. If the interest you received exceeds the threshold, you need to declare the amount through your tax return and pay the amount stated. Basic-rate tax is no longer automatically deducted by banks and building societies. [↩]
  3. If you deposited £20K and subsequently withdrew £10K, some providers wouldn’t let you replace it later, as that would mean you’d deposited £30K over the year. [↩]

The Importance of Building an Emergency Fund

Photo of emergency money
Image courtesy of www.ccpixs.com

As a catastrophist, I’m very good at imagining all the things that could go wrong. Although this means I spend a lot of time worrying, it’s very handy for financial planning. More optimistic people (of whom I’m often envious) tend to assume that everything will be OK. Until it isn’t. Most disasters – such as ill health and unemployment – are completely unpredictable, so it’s important to build an emergency cash fund to protect yourself.

In my last post, I explained the risks of inflation on the value of cash. While this is a significant problem for long-term savings, you still need access to some emergency money. In this post, I’ll help you work out how much you might need and where you should keep it.

How much do I need in my emergency fund?

Well, this depends on your outgoings and what other forms of support are available to you. Hopefully, you’ve read my post on stealth expenses, so have set aside some money for large and sporadic costs, such as boiler repairs and vet’s bills. Let’s look at a few scenarios:

You’re paying off credit card debt – in this case, it might seem sensible to devote the maximum amount to clearing those outstanding balances. However, an unexpected expense or drop in income might force you into borrowing more. Dave Ramsey, squillionaire author of The Total Money Makeover, suggests building a reserve fund of $1,000 (almost £800) alongside your repayments. It’ll take longer to become debt-free, but you’ll have some protection against life events that could throw you off course.

You have heavy financial responsibilities – perhaps you’re the breadwinner, or you have a large mortgage to service. If so, you’ll need a correspondingly large emergency fund, around six months’ outgoings. This would provide a decent buffer if you lost your job or suffered a serious illness. Another option would be to take out appropriate insurance cover. As a financial coach, this is not an area I cover, but I recommend Pete Matthew’s Meaningful Money Handbook for excellent coverage of the types of policy available.

You’re financially comfortable – if you have a partner with a reliable income, or your expenses are modest, you can get away with a smaller emergency fund. Three months’ outgoings might be enough. It could take you longer to recover from a serious blow, but at least you have some time to consider other options.

If you’re finding it tough to put aside extra money each month, take a look at my post on paying yourself first.

Where should I stash my emergency cash?

Photo of the P
Hide your cash behind the Pennines? (Photo by Stemonitis CC-BY 2.5)

Given my warning about inflation, you might be concerned about keeping a cash reserve. However, this is an emergency fund, rather than long-term savings that you’re expecting to grow. You could consider it a DIY insurance policy, and the small amount of money you lose to inflation is the premium. Having said that, some banks are now offering rates that match – and, in some cases, exceed – inflation. You need an account you can access quickly and without penalties, so check the terms and conditions for any attractive-looking deals. Equally, you probably don’t want an account you can dip into too easily – so keep it separate from general spending. In Mind Over Money, Claudia Hammond suggests opening an account with a geographically distant financial institution, e.g. a Lancashire-based building society if you’re in London. Although your money is accessible online, it feels further away.

You can earn up to £1,000 in interest before you’re liable for basic rate income tax.1 Given the current derisory interest rates, you’d need a balance of nearly £60K before that would affect you. For this reason, it’s usually not worth using your ISA allowance, as you don’t benefit from the tax-free status. In my next post, I’ll introduce cash ISAs and explain the circumstances in which they might be appropriate.

In the meantime, please indulge in some modest catastrophising so you can protect yourself against life’s surprises.

 

  1. For higher-rate taxpayers, the threshold is £500 [↩]

Why Cash isn’t King

Photo of banknotes pegged to a washing line
Photo courtesy of https://www.flickr.com/photos/59937401@N07/

In uncertain times, stashing away banknotes can help us feel more secure. This was certainly the case with my grandparents, who kept emergency savings under their pillow. Unfortunately, they forgot and popped all the bed linen in the washing machine. Luckily, the world’s unlikeliest money launderers didn’t lose their savings. As the serial numbers on the notes had survived the spin cycle, the local building society was willing to accept them.1 Even when safely deposited in a savings account, my grandparents’ money remained vulnerable to another threat: inflation.

Inflation is the process by which prices increase over time, and it’s also how money loses its value. The effect is barely perceptible on small amounts of money in periods of low inflation, but it can have a dramatic impact over the long term. This chart shows what’s happened to inflation over the last 10 years. Although the rate has dropped this week to 1.8%, it was over 3% at the beginning of last year.

Of course, your savings are probably earning interest from the bank – but does this rate actually beat inflation? Your money could be shrinking faster than it can grow. Here’s an illustration. Imagine you’re 60 years old and have saved £300,000 in cash for your retirement or withdrawn that amount from your pension pot. Assuming inflation is 3% and you’re earning an interest rate of 2%, your money is shrinking by 1% each year. By the time you’re 85, that £300,000 has the purchasing power of £229,836. To make matters worse, you’re liable for tax on the interest. A basic-rate taxpayer would owe around £1,000 each year based on this scenario.2

Chart showing the effect of inflation
Chart generated by Moneyscope

What you need, therefore, is an interest rate that’s higher than inflation. This isn’t straightforward, though. Many savings accounts pay less than 0.5%, making it almost impossible to achieve growth – especially if you’re liable for tax on the interest.

Over the next few posts, I’m going to present some ideas on how you can grow your money. We’ll look at ISAs, savings certificates, premium bonds, and more. I’ll also introduce you to the basics of investing and how it differs crucially from cash. For now, remember that your money is safe in a savings account, but its value is at risk.

  1. This is unlikely to happen these days. [↩]
  2. You can earn up to £1,000 in interest each year before you start paying tax. For higher-rate taxpayers, the threshold is £500. [↩]