The difference between ISA and savings account? Tax. With a savings account you can pay in as much as you like – depending on any limits set by your provider – and hopefully make some interest on it.
However, that interest you make is taxable. While for most of us with not that much in a savings account (in the UK we’re pretty bad at building a proper nest egg) and historically low interest rates, we don’t need to worry much about tax.
In fact in 2016 we were all given a break where we can make £1000 a year tax-free without having to declare it. That could be interest in a savings account, stock market gains, sidehustles or just selling things on Ebay.
The Personal Savings Allowance
The Personal Savings Allowance (PSA), which came into effect on 6 April, 2016 is £1000 for basic rate taxpayers who earn less than £50,000 a year, or £500 if you earn more than £50,000.
But if you do have a significant amount of savings then you probably do worry about tax on your interest. Especially if you already have a high income which is taxed. It’s worth staying within the PSA if you possibly can just to avoid the hassle of accountants and tax returns.
The ISA Tax Shield
ISAs are a tax-wrapper which means any gains you make are tax-free and don’t count towards your tax liability. So going back to that point about hassle, if you’re paid by Pay As You Earn by your employer then you probably don’t handle your own tax.
If your savings earned enough interest to go over your PSA then you would have to fill in a tax return. But if the savings were in an ISA then you wouldn’t have to.
But the hassle of a tax return is nothing compared to the real benefits of an ISA.
Because we are in historically low interest rates, it is easy to see why many people are frustrated by the low rates offered by banks with savings accounts.
With ISAs there are a variety of different types, but the most common are the cash ISA and the stocks and shares ISA. A cash ISA is just like a savings account with low-risk interest but has the tax advantage. However, a stocks and shares ISA lets you invest in the stock market where the potential returns (and losses) are much greater.
Tax-Free Stock Market Returns
The stock market potentially offers much greater returns for those willing to tolerate a degree of risk and volatility.
The historic returns of the FTSE 100 between 1984 and 2019 are somewhere between 5 and 8%. That includes some pretty big falls like Black Monday in 1987, the Dot Com Bubble and the 2008 Great Recession. It is also several times the average interest rate paid by a bank on a savings account in the early 2020s.
So by investing in the stock market it is easy to smash through that £1000 Personal Tax Allowance and have tax eat away at the returns you tolerated that risk for.
When you invest in an ISA, those returns are shielded. You have an ISA allowance of £20,000 a year. For many people that can seem illogical. You’ve heard about the immense tax benefits of ISAs and yet if you made 5% on a £20,000 investment (£1000), you would only just be tipping over your PSA if you’re a basic rate tax payer. The vast majority of us cannot even afford to pay in £20,000 a year to an ISA.
Growing Your ISA Over Time
The thing is, not only is that year’s return shielded from tax, but so far future returns.
While you may think of yourself as opening an ISA and holding onto it, like a savings account, you are technically opening a new one every year even if you stay with the same provider. When the tax year ends whatever you paid in is in a kind of package. You can’t pay any more into a previous year’s allowance, whether you paid in the full £20,000 or just £200. But that package is now tax free until to withdraw it.
So if we take that historical average of the FTSE as 5% (the low end of the average) and you made £1000 in the first year of the ISA.
You then have £21,000.
Make 5% again the next year and you have £22,050. You’re earning interest on the interest in the compounding effect.
After five years, assuming the same returns, you would have £25,525.
After 10 years £32,577.
You would have made £12,577 and could withdraw it all tax free. Or just keep leaving it to grow.
But we’ve been using the low end of the FTSE average. What if you picked some good stocks and achieved a growth rate of 10% a year, which is not rare.
After 10 years your first year’s ISA allowance would be worth £51,874.85. Tax free.
But if you’re smart, you would have been paying in the full ISA allowance (or as close to it as you can afford) and ending up with lots of of those tax-free packages – last year’s allowance and the year before that – all shielded from tax and growing and growing.
Savings Accounts – Low Interest And Tax
With a savings account, you are unlikely to find similar rates of return just on the basis of the low returns of cash savings vs the stock market. But even if you did, you would be paying tax every year on each of those gains.
That hampers the compounding effect – because while you could have been making gains on gains – interest on interest – you would actually only be making gains on gains minus the tax already deducted.
That is the difference between ISA and savings account. Not whatever interest rate the bank is offering you. Not any loyalty bonuses or extras. It is years and years of tax-free gains or taxes every year on whatever you manage to make.