Cash ISAs are a great savings tool. This is especially true for higher and additional rate taxpayers. You see, any interest earned on money saved inside an ISA wrapper is tax-free. You don’t even have to declare the money on your tax return.
However, as the interest rates offered by new Cash ISAs have fallen, these tax-efficient products have lost a lot of their appeal. Indeed, opening one today could actually make you poorer over the long term.
Under the current tax regime, every saver is entitled to a tax-free personal savings allowance. For example, basic rate taxpayers are entitled to a savings allowance of £1,000. That means the first £1,000 of interest you earn on savings is tax-free. Any money over this level is taxed at 20%.
For higher rate taxpayers, the allowance falls to £500. Income over this level attracts a 40% tax charge. So, if you have a lot of savings, opening a Cash ISA could save you from getting a big tax bill.
Unfortunately, over the past 10 years, the average interest rate on Cash ISAs has dropped substantially. The best product on the market at the moment offers an interest rate of just 1.31%. You can earn more interest if you’re willing to lock your money away, but even these rates are pretty poor.
The thing is, inflation in the UK is currently 1.4%. So, the best Cash ISA on the market has a real interest rate (after inflation) of -0.09%. That implies that your hard-earned cash will lose 0.09% in purchasing power every year if it’s stashed in an ISA.
The best way to get around this problem is to open a Stocks and Shares ISA. These products offer precisely the same tax benefits as Cash ISAs. The big difference is, you can buy stocks and shares.
Investing is one of the best ways to beat inflation over the long term. For example, since its inception three-and-a-half decades ago, the FTSE 100 has produced an average annual return for investors in the region of 9%. Over the same time, inflation has averaged around 2%. This means the index has produced a return after inflation of 7%.
These gains make the return on the average Cash ISA today look extremely poor. To replicate the performance of the FTSE 100, all you need to do is buy a simple, low-cost passive index tracker fund. Then you can sit back, relax, and let the market do the hard work for you.
The one issue with this strategy is that stocks tend to be much more volatile than cash. That could be bad news for short-term investors.
So, if you are planning to use your cash in the next year or two, this strategy is probably not for you. However, if you are saving for the next five or 10 years, opening a Stocks and Shares ISA and buying a low-cost FTSE 100 tracker fund could be the much better strategy. It might also help you reach your financial goals much faster.
For example, £1,000 invested for 10 years at a rate of 9% per annum would grow to be worth £2,450 at the end of the decade. The same £1k invested at a rate of 1.31% would be worth £1,139.
These figures clearly show why the FTSE 100 could be the better place for your money over the long run.
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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.