Don't fall for this lie about ISAs

Whether or not you're planning to take out an ISA this year, watch out for this lie - or your savings will suffer!

You probably didn’t stay up until midnight to welcome it in singing Auld Lang Syne, but a new tax year began yesterday, and with it came a brand new tax-free savings allowance. Everyone can now save up to £5,100 in a bank account, without having to pay a penny in tax to HMRC - as long as you deposit the money into a Cash ISA.

The question is: should you bother?

Poor rates

Unfortunately, a closer look at some of today's best-buys reveals rather disappointing rates. For example, the top easy access cash ISA is the Santander Flexible ISA, which offers a return of just 3.2%. This has led many commentators to the conclusion that ISAs just aren't worth it, and ISA providers are ripping savers off with appallingly low rates.

In fairness, this is a feature which applies to all sorts of savings accounts in the current low-interest environment. Nevertheless it doesn't seem like a great advert for tax-free saving when the top returns from cash ISAs are so low. The most competitive easy access savings accounts pay up to 3% right now, so where's the incentive to put your money in an ISA? It hardly seems worth it for an extra 0.2%.

But that’s because you’re forgetting something. ISAs pay a tax-free return. Even when the headline rates seem lower than comparable taxable accounts, the actual amount of interest paid is greater.

Just take a look at the table below which compares the best tax-free ISA with the top taxable account with true easy access:

Taxable versus tax-free savings accounts

As you can see from the table, basic rate taxpayers and higher rate taxpayers would be significantly better off going for the Santander Flexible ISA instead of the Halifax Web Saver Extra. With this ISA all savers will receive a current return of 3.2% tax-free regardless of their tax bracket. 

But basic rate taxpayers who open the Halifax Web Saver Extra account will only earn a net return of 2.24% once 20% tax has been deducted (if they’re not already Halifax current account customers). Meanwhile, higher rate taxpayers (who aren’t existing Halifax customers) will get an even worse rate of just 1.68%, with a 40% tax deduction.

For the Halifax account to beat the returns from the Standard Life ISA, it would need to pay a gross rate of 4% for a basic rate taxpayer, and over 5.33% for a higher rate taxpayer.

In these circumstances, the Santander Flexible ISA would be a far better choice for any tax payer. And remember, you don’t need a lump sum to invest in it. You can open the account with as little as £1 to ensure you get the high rate before it’s withdrawn, and then add to this sum as often as you like throughout the tax year, as long as you don’t exceed the £5,100 Cash ISA limit.

Of course, if you have more than £5,100 of savings to invest right now and you need easy access to your savings, the Halifax Web Saver Extra would be one of your best options.

ISA transfers

So far we've looked at the best home for your ISA savings for this tax year. But what about your old ISA cash? Did you know you could step up your return by switching into a best-buy ISA which accepts ISA transfers?

Again, Santander is leading the market. The Santander Direct ISA issue 6 is a great choice with a market-leading rate of 2.75%. To earn this return you'll need to open the account with a minimum balance of £9,000 (balances below this amount earn just 2%). You should remember the rate includes a 2.25% bonus which disappears after 12 months. So, the chances are, you'll need to transfer your ISA savings again at this time to keep on earning the most competitive rate.

Why ISAs still make sense

There's no escaping the fact that savings rates are low across the board, and with inflation at 3%, the situation is worsening. That said, I still think it's a good idea to use up as much of your ISA allowance as you can possibly afford.

Think about it this way: at some point the financial crisis will normalise, the base rate will increase and savings rates will improve. When this happens, you'll be in a great position to transfer all your ISA money to the market-leader at that time, where you'll enjoy a much healthier tax-free return on more of your cash. Remember any allowance you don't use up by the 5 April deadline each year will be lost forever.

So if anyone ever tells you ISAs are a rip-off right now - put them straight. You're not only saving tax on your investment this year, you're saving tax each and every year you hold that ISA. Even if it doesn't seem worth it right now, it may well be worth it in the future.

If you have a question about tax-free saving, ask other lovemoney.com readers for help via Q&A. And join our Build up your savings goal to help you save as much as you can.

Compare ISAs at lovemoney.com

This article has been edited and updated from an earlier version published in January 2010.