COMMENT
How Smarter Saving Makes You Richer

By Cliff D'Arcy
November 24, 2005

Earlier this month, a friend asked me whether it was really worthwhile scouting around to earn another, say, 1% or 2% a year on his savings. Naturally, I replied, "Of course it is, because small differences in your annual returns make for big differences, especially when in the long run". Here's an example of what I mean:

Let's say that you decide to keep £3,000 in spare cash to pay for the occasional problems that crop up in everyday life. Ideally, you don't want to dip into this fund but, if you find yourself sick or out of work, you have the option of dipping into this pot.

Most of us would stick this money into a bog-standard savings account earning, say, 3% a year before tax. For a basic-rate taxpayer paying 20% savings tax, this 3% a year falls to 2.4%; for a higher-rate taxpayer, it reduces to a paltry 1.8% a year, which doesn't even beat the current level of inflation (rising prices).

On the other hand, a smarter saver might decide to deposit this three grand into a Best Buy tax-free cash mini-ISA, for example, one which pays 5% a year. (You'll find this account here.) Here's how £3,000 at these three different interest rates (5%, 2.4% and 1.8% a year) grows over time. I've assumed that, thanks to careful budgeting and sensible forward planning, all goes well and you don't need to withdraw any of this cash:

Timescale	Value (£) at 5% a year	Value (£) at 2.4% a year	Value (£) at 1.8% a year
One year	3,150	3,072	3,054
Five years	3,829	3,378	3,280
Ten years	4,887	3,803	3,586
Twenty years	7,960	4,821	4,286

So, after ten years, tax-free interest of 5% a year turns your £3,000 into £4,887, which is £1,084 more than the after-tax 2.4% a year, and £1,301 more than the 1.8% a year that a higher-rate taxpayer hangs on to after losing 1.2% of his 3% to the taxman.

Thanks to the amazing power of compounding, after twenty years, the difference is even more extreme. At 5% a year tax free, your £3,000 grows to £7,960, which is £3,139 more than you'd have earned at 2.4% a year, and £3,674 more than you'd have earned at 1.8% a year.

Hence, if you pay tax, having a Best Buy cash mini-ISA is miles better than having a second-rate savings account that pays taxed interest at an inferior rate. Indeed, I'd go as far as to say that, if you are sixteen or over, putting the first £3,000 a year of your savings into a cash mini-ISA is a complete no-brainer!

Finally, if you're thinking about putting money away for the medium to long term, say, ten years or more, then cash probably isn't what you're after. I say this because, since the end of the First World War, the UK stock market has produced an average annual return of around 11%, with income reinvested. Therefore, if you're playing a long game and you're prepared to ride out the inevitable ups and downs of investing in shares, then you may find a cheap, simple index tracker is a better bet!

More: Open a Best Buy cash mini-ISA or an index tracker today! | Find a superior savings account.