What Are the Differences Between an ISA and a Savings Account?

A guide from IG gives a good overview, comparing the benefits of ISAs versus normal savings accounts. It points out that ISAs have advantages when it comes to tax.

Saving money is an important part of financial planning, but with so many options available, it can be confusing to know where to put your money. Two popular choices in the UK are ISAs and savings accounts, each offering their own benefits and drawbacks. In this article, we will explain the differences between ISAs and savings accounts, to help you make an informed decision about where to invest your hard-earned cash.

What is an ISA?

An ISA, which stands for Individual Savings Account, is a savings or investment vehicle that comes with tax advantages. One of the key benefits of ISAs is that you can save up to £20,000 per tax year from your net income across multiple accounts, and any returns you earn are free of income tax, capital gains tax, or dividend tax. There are different types of ISAs, including instant access, regular savings, fixed rates, and investment ISAs. Each type has its own advantages and drawbacks.

With an ISA, your savings interest is tax-free and your initial capital is protected. However, it’s important to note that if the interest rate is lower than inflation, the value of your money may erode over time. Investment ISAs allow you to invest in shares, bonds, and investment funds without paying capital gains or dividend tax. However, investment returns are not guaranteed, and you may end up with less than what you put in. It’s worth noting that equities have historically outperformed cash over the long term.

There is also a type of ISA called a Lifetime ISA (LISA). With a LISA, you can save up to £4,000 per year, and the government will top up your savings by 25% up to £1,000 per year until you turn 50. This means that if you fully utilize your LISA allowance, you will have £16,000 left to invest in other ISA accounts. The money in a LISA must be used to buy your first home or can be withdrawn when you reach the age of 60. Opening a LISA is only possible if you are between 18 and 40 years old, and early withdrawals may incur a penalty charge.

Another type of ISA is the Innovative Finance ISA (IFISA), which allows you to invest in peer-to-peer loans or buy business debt. While this type of ISA offers higher potential returns, it also comes with higher risk. It’s important to note that many peer-to-peer loans are not covered by the Financial Services Compensation Scheme (FSCS) protection.

It’s worth considering a few important points about ISAs in general. The power of compounding returns is greatly amplified in an ISA because returns are not reduced by taxes. Investing-based taxes have been rising over time, making ISAs more attractive. However, it’s important to keep in mind that the government can make changes to ISAs at any time. There are ongoing campaigns to simplify ISAs into one account type and to reduce the amount that can be saved. ISAs are also extremely generous compared to international standards, as most countries only offer one benefit or the other. Lastly, the use-it-or-lose-it aspect of ISAs means that your allowance resets at the beginning of each tax year.

What is a Savings Account?

A savings account is a simple account where you deposit money and earn interest on that money. The amount of interest you earn depends on the terms, limits, and restrictions of the account. Generally, the longer you keep your money in the account and the more restrictions on withdrawals, the higher the interest rate.

There are three main types of savings accounts in the UK: notice savings accounts, easy access savings accounts, and fixed-rate bonds. Notice savings accounts require you to give notice before making a withdrawal, but they typically offer more competitive interest rates than easy access accounts. Easy access savings accounts give you the flexibility to deposit and withdraw your cash whenever you want. Fixed-rate bonds provide guaranteed returns over a set term but lock your money away during that period.

Similar to ISAs, the deposit and interest earned in savings accounts are protected up to £85,000 per person per banking group if the institution offering the account is regulated and based in the UK.

Savings accounts are a good option if you have short-term goals, such as saving for a house deposit in the near future. However, if you have long-term goals, investing in a stocks and shares ISA may be preferable, as equities tend to outperform cash over time.

Differences between ISAs and Savings Accounts

There are several key differences between ISAs and savings accounts:

  1. Tax: The main difference is that with an ISA, you won’t be taxed on savings up to £20,000 per year, whereas with a savings account, you can earn up to £1,000 tax-free (for basic rate taxpayers) or up to £500 tax-free (for higher rate taxpayers). Returns in savings accounts are usually higher than in cash ISAs, so if you’re unlikely to be liable for tax on the interest generated, a savings account may be a better option.
  2. Deposit Limits: In ISAs, you can deposit up to £20,000 per year and pay into one of each type of ISA per year. There are no deposit limits for savings accounts, and you can open as many accounts as you want. This means you can switch accounts to take advantage of better interest rates without penalty.
  3. Ease of Access: With an ISA, you can withdraw your money at any time, but be aware that in some ISAs, the withdrawn amount will still count towards your annual allowance. Flexible ISAs, however, allow you to withdraw money without affecting your allowance. Easy access savings accounts also offer this flexibility. There is one exception: the Lifetime ISA. Withdrawing money from a Lifetime ISA for purposes other than buying a first home or at the age of 60 incurs a penalty charge of 25%, which is higher than the 25% government top-up.
  4. Risk Factors: ISAs offer different levels of risk depending on the type of investment you choose. Stocks and shares ISAs rely on the performance of the companies you invest in, and returns are not guaranteed. Innovative finance ISAs, on the other hand, carry a higher risk due to their nature. Savings accounts, whether cash ISAs or traditional savings accounts, do not carry the risk of capital loss. However, if your interest rate is below the rate of inflation, the real value of your cash may erode over time.

Deciding between ISAs and savings accounts depends on various factors, including your risk tolerance, age until retirement, available funds, and expected future earnings. Many investors choose to split their capital between different accounts to manage risk.

In conclusion, ISAs and savings accounts offer different benefits and drawbacks. ISAs provide tax advantages and the potential for higher returns, but they come with restrictions, including deposit limits and penalties for early withdrawals in some cases. Savings accounts, on the other hand, offer flexibility and security but may have lower interest rates. Consider your financial goals and personal circumstances to determine which option is best for you.