ISA vs savings account: what’s your best option?

So you’re thinking about saving your money. Great idea! There’s a lot to get your head around, and lots of different types of savings accounts that have different benefits, so you’ll want to find one that suits you. And that’s what we’re here for!

Along with the ‘normal’ savings accounts that you might find at your bank or building society, you also have a choice of ISAs – a.k.a. Individual Savings Accounts.

An ISA is a bit different to a normal savings account, and they’ve got much more benefits which will typically grow your savings a lot more over time. This article will explain, simply, everything you need to know and your best savings option.

So, ISA vs savings accounts, what's the difference?

Savings accounts

What is a savings account?

A savings account is basically a piggy-bank that expands. It holds your money. And because your savings generate interest, it makes you money too!

But how does your money increase?

When you open a savings account, you can earn money from the amount you save – called interest. Different accounts offer different interest rates (that’s the percentage of your money that you earn from your savings.)

In practice, it looks like this:

The average interest rate for a savings account in the UK for 2021 was 0.35% (data from Swanlowpark). 

That means, if you deposit £1,000 into your account with a 0.35% interest rate, they’ll give you an extra £3.50 on top of that to add to your savings every year. Yep, it’s that low. How tight is that from the banks raking in billions of pounds per year?!

There are some standard savings accounts with higher interest rates, but they don’t tend to get much bigger than 3% right now (3% means £30 from your £1,000). And these higher rates are often designed to attract new customers, and then the rate drops over time. Loyalty doesn’t pay!

But don’t just choose the savings account with the highest interest rate. Have a look at the type of savings account too:

• If you choose a regular savings account, you’ll probably be required to put away a certain amount each month (regularly). While you can find interest rates of 3%, these rates are often only fixed for a year before they drop way down. They might also have a limit on your number of withdrawals (the amount of times you can take money out of your account per year), and/or a cap on how much you can save per year. 
  

• If you choose an easy-access or instant-access savings account, you get more flexibility but a much lower interest rate. And this interest rate is often variable, meaning it can go up and down with little notice. The advantage is there are rarely limits on withdrawals or deposits (putting money into the savings account), which makes them a good choice if you need quick access to your money.
  

• If you choose a notice account, you’ll be required to give a certain amount of notice before withdrawing your money. This might be 45 days, for example. But it changes based on your savings account provider (i.e. your bank or building society). Generally, the longer the notice period, the higher the interest rate.
  

• If you choose a fixed-rate account, you’ll be setting aside a lump sum of money for a certain period of time. Generally, the longer the time, the higher the interest rate you’ll get. And sometimes, the more money you put in, the higher the interest rate. However, withdrawing early involves costly fees.

Your Personal Savings Allowance

Each year you get a Personal Savings Allowance from the government, which means some or all of the interest you make in a normal savings account (not an ISA) is tax-free! Here’s how much you’ll get:

Let’s use an example to explain how it works. Imagine you have £20,000 in savings, and you have a savings account with 3% interest – you’d earn £600 in interest per year.

If you were a basic rate taxpayer, all of your interest would be tax free as it’s under your £1,000 Personal Savings Allowance.

If you were a higher rate taxpayer, you’d have to pay tax on £100 of your interest, as you’d be earning £600 in interest, but your Personal Savings Allowance is £500 (£600 - £500 = £100).

And if you were an additional rate taxpayer, you’d pay tax on all of your savings. Isn’t it tough at the top?!

Watch out for inflation

One important thing to know when you’re saving is inflation. Inflation is the rising costs of goods and services of everyday things such as food and energy bills. And it’s currently very high!

Here’s an example: in the year 2000, a pint of milk cost 31p, and in 2022 the same pint of milk cost 55p – nearly double! That’s inflation at work.

Inflation is outpacing interest rates on savings accounts. What this means is that when you have an inflation rate of 6% (which it has been in 2022), but an interest rate of 1%, the ‘buying power’ of your cash is reducing, by around 5% per year (6% - 1% = 5%). 

Which means your money can roughly buy 5% less things this time next year. That’s quite a  big deal – your hard earned money is losing value, fast!

So, how do you beat inflation? 

The best way to beat inflation is to save your money within certain types of ISAs.

Let’s dive into what they are and how it works.

ISAs

What is an ISA?

An ISA is a type of savings account with one major benefit: you can save and grow your money completely tax-free!

There are five types of ISAs—Cash ISAs, Stocks and Shares ISAs, Lifetime ISAs, Innovative Finance ISAs, and Junior ISAs.

Cash ISAs are pretty similar to savings accounts. You can get easy-access Cash ISAs or fixed-rate Cash ISAs that lock your savings away for a certain period of time (1-5 years). Just like a savings account, usually, the longer the term, the higher the interest rate. The very best rate right now is around 1.75%, so if you put away £10,000 with that rate, you’d get £175 in interest per year.

Stocks & Shares ISAs give you the opportunity to invest your money in successful and growing companies by buying shares in the companies themselves (shares are small bits of ownership). They’re significantly more fruitful than Cash ISAs, because your money grows when your investments do well.

As a rule of thumb you could expect around an 8% per year increase on average. Which means that if you put away £10,000 at 8% growth, on average you’d make £800 per year.

The best bit is you don’t even have to lift a finger. Experts handle everything for you. Just sit back, relax and watch your money grow.

An Innovative Finance ISA is somewhat similar to a Stocks and Shares ISA, but you do something called ‘peer-to-peer’ lending instead. This is where you lend money via your ISA to companies or people who need it. You get more money back because the people who borrow it pay interest on the loan. ‍

Lifetime ISAs are designed for you to save for your first home or for later in life. You can save up to £4,000 every tax year (from 6th April to 5th April) and the government will top it up by 25%.

So, if you manage to save that £4,000, you get £1,000 extra! Amazing. And, these can either be a Stocks & Shares Lifetime ISA or a Cash Lifetime ISA, which act in the same way as their ‘normal’ version.

The downside is that you have to pay 25% to withdraw your money if you don’t use it for your first home or before you’re 60. So make sure you don’t need the money for anything else.

‍Junior ISAs are designed for you to save money for your kids' future. You can get a Cash Junior ISA or a Stocks and Shares Junior ISA, and add up to £9,000 per year per child. This will then become their money and they can do what they want with it when they turn 18.

What are the benefits of an ISA?

The biggest benefit? You guessed it – no tax! And that goes for all types of ISAs.

The government gives you an ISA allowance of £20,000 every tax year. (The tax year runs from 6th April to 5th April.) This means you can save £20,000 every year across all of your ISAs – except if you have a Junior ISA, which has a separate allowance of £9,000.

So, put simply: you can spread your allowance across your Cash ISA, Stocks and Shares ISA, Innovative Finance ISA, and Lifetime ISA. Everything you earn on the money you save or invest is totally tax-free. ISAs are the only savings accounts that offer this benefit.

You can earn a lot from certain types of ISA. Namely a Stocks and Shares ISA and a Lifetime ISA, which will likely outpace inflation and grow your money much more than a savings account.

And the best bit, you don’t even have to do anything! Experts can handle everything for you.

Your best savings option

If you’re thinking about growing your money over the long-term, a Stocks and Shares ISA is a must-do, and your best option.

You’ll make lots more money over time than a savings account or a Cash ISA.

With a Stocks & Share ISA, instead of earning interest each year, like a savings account, your money grows based on how well businesses are doing, such as increasing sales, and therefore becoming more valuable.

This works because your money buys shares in these companies –  bought on the stock market (a place to buy and sell shares), and these shares represent ownership of those companies, meaning when you own shares, you own part of the company.

And when these companies grow in value, so does the value of their shares! And there’s no limit to how big a company can grow, or how many companies your money can be invested in.

The best bit, you don’t need to do any of this yourself. You can simply open a Stocks & Shares ISA and the experts will handle everything for you. They’ll know which shares to buy and which investments to make, all while using the safest investment strategies.

This is why over time you can make a lot more money than a savings account – your money is linked to businesses and essentially the economy as a whole, which tends to grow over time. Rather than a set interest rate that's below inflation, where your money would actually be losing value over time.

Learn more about Stocks & Shares ISA, and how to get started with our guide to investing for beginners (UK).

ISA vs savings accounts: the takeaways

Currently, most savings accounts have insanely low interest rates, meaning you’re actually losing money over time as inflation (the cost of goods and services) increases – your cash balance won’t go down, but what you can buy with your cash goes down, so over time your money can buy less things.

Cash ISAs have the same issue, as they are effectively a savings account, but with tax-free benefits.

Stocks and Shares ISAs stand high above the rest in terms of the money you can make. And this is your best option when it comes to long term saving. If you’re ready to get saving, learn more about Stocks & Shares ISAs and the best investment apps in the UK.

Here’s a quick recap:

• Tax: with an ISA, you don’t pay any tax on the money you earn, nor when you withdraw your money. With a savings account, you may have to pay tax on the interest you earn if your interest is above your Personal Savings Allowance (which depends on your total income).
  

• Savings limits: with ISAs, you have an annual allowance of £20,000 – which can be spread across multiple types of ISAs. With a savings account, you can generally deposit as much as you want unless your account provider has a limit.
  

• Returns (i.e. how much money can you make?): Cash ISAs are pretty similar to normal savings accounts in terms of the interest rates available. Stocks & Shares ISAs are on a different level when you’re looking for long-term financial growth. No savings account can really compete with the returns you get – a good rule of thumb is 8% per year on average.‍

Note: Stocks & Shares Lifetime ISAs are also awesome—that sweet 25% top-up from the government. But they’re only useful if you’re saving for your first home or later in life.

• Safety and security: the only ISA that isn’t protected by the Financial Services Compensation Scheme is the Innovative Finance ISA. Otherwise, you’re protected up to £85,000 per provider should anything bad happen to the provider, such as going out of business (very unlikely anyway). Which means you’ll get your savings back.
  

• Number of accounts: overall, you can have as many ISAs as you want – but you can only open one of each type of ISA every year. With savings accounts, there’s no limit to the number of accounts you can open at any time.
  

• Access to your money: almost all savings accounts (including ISAs) allow you to get hold of your money if you really need it. It’s just that some will charge you fees for withdrawing earlier than you’ve agreed. So make sure you check!
  

Happy saving!