Why rising savings rates are putting cash ISAs back into the spotlight

You’ll be forgiven for thinking that cash ISAs haven’t been worth the bother over the past few years. Rates have lagged behind normal savings accounts. Meanwhile, the tax advantages of ISAs haven’t been relevant for the majority of savers in an era of low rates.

Yet things have recently taken a turn. Savings rates are rising fast, which has put cash ISAs back into the spotlight. Here’s everything you need to know…

What is a Cash ISA?

A cash ISA is a tax-free savings account. In other words, you don’t have to pay tax on any interest you earn from money held in an ISA.

You can put up to £20,000 into an ISA in the current tax year. However, you can’t carry over any unused part of a previous years’ ISA allowance—so if you don’t put £20,000 into an ISA before the current tax year ends (5 April 2024), then you won’t get another opportunity to do so.

Importantly, the annual ISA limit applies to all types of ISA. So, if you have (or open) a cash ISA AND a stocks & shares ISA, you can only put in up to £20,000 across both of them during the same tax year.

It’s worth understanding that anything you save in an ISA stays tax-free year-after-year.

Why are interest rates rising?

The world economy is changing. Interest rates are being hiked globally as Central Banks try to ward off rising inflation. The Bank of England hiked its base rate for the 14th consecutive time on 3 August 2023, and now stands at 5.25%. Plus, it's likely we haven't seen the end of rising rates just yet.

Rising interest rates have a big impact on almost all of us. A higher base rate—by definition—increases the cost of borrowing. This can lead to new mortgages and personal loans becoming more expensive.

Yet higher borrowing costs is generally GOOD news for savers. We’ve seen evidence of this over the past year or so, as savings providers are now having to raise their savings rates in order to attract deposits from retail savers.

What savings rates are available right now?

When looking at non-ISA accounts, the top easy-access savings account pays 5% AER variable via Furness BS. That’s a far cry from the sub-1% market-leading rates we were seeing in 2021, and in the early half of 2022.

If you’re happy to lock away cash, it’s possible to earn up to 6.01% AER fixed for one year, and up to 5.8% AER fixed for five years.

Given the fast-changing environment, savings rates are changing regularly. See our best savings guide for more options.

What Cash ISA rates are available?

It’s fair to say that cash ISA savings rates are still lagging behind normal savings accounts. Despite this, rates are certainly climbing.

The top easy-access cash ISA account pays 4.5% AER variable via Newcastle Building Society. However, Newcastle’s account only permits two penalty-free withdrawals per year or the rate drops to 2.9%. Paragon Bank also pays 4.5% AER variable, though it also restricts the amount of withdrawals you can make per year. If you withdraw your cash more than two times in a year, then the rate drops to just 1.5%.

Understandably, fixed ISA rates are more generous. The top one-year fixed ISA account pays 5.77% AER, while the top five-year fix pays 5.26% AER.

Cash ISA v normal savings

While cash ISA rates are going in the right direction, rates are still less than those offered on normal savings accounts. Despite this, there are two big reasons why you may wish to consider opening an ISA over a normal savings account. Let's take a look at the reasons:

1. Saving in a non-ISA account may attract tax.

When savings rates on normal savings accounts were pitiful, most savers didn’t have to worry about paying tax on savings interest. This is all because of the Personal Savings Allowance (PSA).

Under the PSA, basic-rate taxpayers in the 20% tax band can earn £1,000 per year in savings interest without having to pay tax on it. For higher-rate taxpayers in the 40% tax band, it’s £500.

Given that savings rates have been so low over the past few years, only those with lots of savings would have come close to breaching their PSA.

Yet given savings rates have now risen substantially over the past few months, it's likely more savers will be required to pay tax on savings interest earned through normal savings accounts. Of course, one way to avoid tax on savings interest is to open a cash ISA, which is why many savvy savers are likely to show a greater interest in cash ISAs going forward.

2. You can withdraw cash from a fixed ISA.

The idea of a fixed savings account is that you can earn a boosted interest rate in return for losing access to your money for a set period. The longer the fixed term, the higher the interest rate you can expect to earn.

While fixed savings accounts pay higher rates than fixed ISAs, there is one crucial difference between them.

With cash stashed in a fixed non-ISA savings account, your money is truly locked away. With fixed cash ISAs, however, you've a legal right to access your money. This rule means that if you opt for a fixed cash ISA, you technically aren’t locking away your money for good—you’ll be able to access it if you really need it, which can be reassuring if you worry about financial emergencies.

This is why opening a fixed cash ISA may be attractive for savers keen to beat easy-access rates, but reluctant to lock away cash. A word of warning though—most fixed ISA providers would prefer you didn’t access your cash before your fixed term ends. So, to disincentivise withdrawals, providers will usually charge an interest-penalty on the amount withdrawn. So, while you can access to your cash in a fixed ISA, it’ll cost you.

Because of withdrawal penalties, opening a fixed cash ISA with the intention to access your cash early may not be the smartest of moves. Instead, it’s probably best to consider the option of withdrawing cash early as an added insurance policy that comes with opting for an ISA over a non-ISA account.

Please note that tax treatment depends on your individual circumstances and may change in future. The content in this article is provided for information purposes only. It is not intended to be, nor does it constitute, any form of tax advice.