The trouble with Cash ISAs
Filed under: Investing
I used to be a big fan of cash ISAs, having opened my first one over a decade ago when Smile bank was offering a mouth-watering 7.25% (if memory serves me correctly). It served me well for a while, until I discovered...
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The initial "teaser" rate on that cash ISA was not maintained, and it fell in subsequent years irrespective of the direction of the bank base rate, although I acknowledge that Smile was not one of the worst offenders in this respect.
A couple of years later, I used a new ISA allowance to invest in an alternative market-leading (at the time) National Savings cash ISA. I seem to remember that this new account would take my new tax year deposit, but would not transfer in my accumulated Smile ISA balance at the new attractive interest rate.
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This illustrates the problem with cash ISAs: that it is all too easy to deposit this year's allowance into an account that offers a headline-grabbing interest rate, which then falls in subsequent years. This can leave you with a zombie account that cannot easily be transferred to a better interest rate elsewhere, and from which you daren't withdraw funds for fear of losing the "tax-free" status.
Despite a recent article in the Money section of The Sunday Times on 8 April declaring "Rate boost for cash ISA savers", the fact remains that many of the headline accounts are boosted by a one year only bonus and are restricted when it comes to transfers in.
One possible way to mitigate the problem might be to deploy each year's allowance into whichever new-issue ISA offers the highest interest rate at the time, rather than topping up an existing ISA, and then withdraw funds -- if ever you need to -- from the poorest paying (most likely the oldest) account on a kind-of first in / first out basis. Then all the time keep looking for opportunities to transfer your accumulated zombie funds held with different providers into better-paying ISA accounts that will accept those transfers. But this could require a lot of time, effort and research.
Let me offer an alternative by suggesting that...
A stocks & shares ISA might be better
One advantage of investing in a stock & shares ISA is that you can invest more money: £11,280 in the 2012-2013 tax year compared with half that amount, i.e. £5,640, in a cash ISA.
Alternatively, you can split your total allowance by depositing £5,640 in a cash ISA and depositing the balance of £5,640 in a stocks & shares ISA, but to me this is akin to investing in one of those halfway-house "have your cake and eat it" structured products that promise some safety combined with some market return. Personally, I would prefer all of the money to be at the mercy of the market, because then I'm in control.
I'm not in complete control, of course, because Mr. Market has a say in what happens to my share investments, but ultimately the return I get is a function of my own investing ingenuity. My return is not limited to the single-digit interest percentage set by the cash ISA provider initially. And it won't be cut on a whim in the second and subsequent years, thereby compelling me to open yet another ISA account.
From cash to stocks & shares
I'm not saying that cash ISAs are all bad, or always bad. They serve an important purpose for those of us who want to save tax-free with no downside risk and no obligation to fill out the details on a Self Assessment tax return. And that initial teaser interest rate can be very attractive.
Since the HMRC allows you to transfer a cash ISA into a stock & shares ISA (but not vice-versa), why not take the attractive cash ISA for the first year bonus and then -- in the second year, as soon as interest rate becomes less attractive -- transfer the accumulated cash into your stocks and shares ISA?
Foolish bottom line
Tax-free saving via an ISA is good, but it can get less good over time as the account provider ratchets down the interest rate. The return you get from a stocks & shares ISA is entirely down to you (and Mr. Market), and is not subject to the whims of the cash ISA providers that rely on your investing inertia.
Personally, I want control over my investment returns, and I'm willing to live or die by my own investment sword, so for me the stocks & shares ISA is the better option. But it's risky (in the true financial sense) and it might not be the better option for everyone.